Whether a retirement plan should or shouldn’t offer plan loans, and whether participants actually understand the impact retirement plan loans have on the retirement savings are complicated questions; however, once plan loans are allowed, the complexities continue. Plan administrators can find it difficult to ensure compliance with the loan rules set forth in the Internal Revenue Code, corresponding regulations and the adopting plan documents (which are often comprised of loan policies and/or administrative procedures).
As a practical matter, repayment of retirement plan loans is most often achieved through automatic payroll deduction. In special situations, like corporate divestitures, Plan loan repayments may also be permitted by participants through manual coupons. However, automatic or manual payments can be missed for a variety of reasons in different situations, including during an unpaid leave of absence and/or following a termination of employment. Not adhering to the repayment schedule can be problematic as the Code’s plan loan rules provide that if a participant receives (directly or indirectly) a loan from a qualified employer plan (including a 401(k) or 403(b) plan), then the amount of the loan is treated as having been received by the participant as a plan distribution unless the loan meets certain detailed requirements, including that the loan requires substantially level amortization of the loan (with payments not less frequently than quarterly) over the term of the loan. Thus, missing repayments and “defaulting” the loan means including the outstanding loan amount in the participant’s income (as a deemed distribution) as of the failure date.
In recent guidance (Chief Counsel Advice 201736022), the IRS describes two factual scenarios which explain when missed loan repayments will not trigger a deemed distribution despite missed payments which could be interpreted as violating the level amortization requirement.
Background (for both Scenarios)
Taxpayer is a participant in a 401(k) plan that permits plan loans. On January 1, 2018, she receives a loan from the plan in an amount that does not exceed the statutory limit and otherwise meets the applicable statutory/regulatory requirements.
Level installment payments are due at the end of each month of the loan's term, with the first payment due January 31, 2018, and the last payment due December 31, 2022.
The plan also allows for a cure period pursuant to which a participant can make up a missed installment payment by the last day of a calendar quarter following the calendar quarter in which the payment was due.
Taxpayer makes timely installment payments from the period running January 31, 2018, through February 28, 2019, but then misses the next two payments (due March 31, 2019 and April 30, 2019).
Taxpayer makes installment payments on May 31, 2019 (which is applied to the missed March 31, 2019 installment payment) and June 30, 2019 (which is applied to the missed April 30, 2019 installment payment).
On July 31, 2019, Taxpayer makes a single payment equal to the amount of three installment payments (which is applied to the missed May and June, 2019 installment payments, as well as the required July 31, 2019 installment payment).
Taxpayer makes timely installment payments from January 31, 2018, through September 30, 2019, but then misses the next three payments (due October 31, November 30, and December 31, 2019).
On January 15, 2020, Taxpayer refinances the original loan and replaces it with a new “replacement” loan equal to the outstanding balance of the original loan, including the three missed payments.
By its terms, the replacement loan (which is assumed to satisfy the statutory/regulatory) is to be repaid in level monthly installments at end of each month through the end of the original loan's repayment term (i.e., December 31, 2022).
Result and Reminder
The IRS opined that a “deemed distribution” is not triggered in either Scenario. In both situations, the missed installment payments do not violate the level amortization requirement because they were cured within the applicable cure period.
Note – a permissible cure period cannot be extended later than the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.
While this type of guidance (issued as Chief Counsel Advice) cannot formally be used or cited as precedent, it provides insight into the IRS’s stance on these matters.
Perhaps more importantly, this guidance serves as a good reminder to consider a plan loan “check-up”. Are your loans being administered in a manner that complies with IRS guidance and governing plan documents? In particular, you might consider vetting your plan document (including loan policy/administrative procedures, as applicable) to confirm (1) whether a (permissible) cure period is included, and (2) whether missed repayments take into account any cure period before triggering/reporting a deemed distribution.
A plan loan check-up will help plan administrators fulfill their fiduciary duties and minimize any surprises that may arise during a government or routine annual plan audit.