Can anything be done to help participants whose loan is in default?

A cure period may help. Here’s how. Most plans have a grace period, called a cure period, which goes up to the last day of the calendar quarter following the calendar quarter in which the required loan repayment was due, so if payments stopped in April the grace period extends all the way up to September 30.

If an employee fails to timely make a loan payment, the remaining balance of the loan is treated as a taxable distribution and generally will also be subject to an additional 10% tax if the employee is not at least age 591/2 at the time of loan default.

Some other options include:

  • Participants may repay or paying the loan down using severance pay.
  • Plans may allow loans to continue beyond termination of employment. While usually loans are repaid via payroll, the law does allow participants to continue making loan payments even after termination of employment via check or ACH. If not allowed currently, the loan policy and/or plan document need to be amended.
  • A loan may be rolled over into another retirement plan with a new employer (plans must allow for such rollover).
  • New option under the 2017 tax reform allows a loan to be repaid to an IRA by the due date of tax return including extension (e.g., April 15, 2021 + extensions for 2020 events). If a participant meets the definition of a “qualified individual” under the CARES Act, then he or she may be able to delay loan default by one year and then extend repayment into IRA to 4/15/2022 including extensions.
  • The CARES Act option: if participant is a “qualified individual” under the CARES Act, the loan offset distribution should qualify as a CARES Act distribution eligible for a favorable treatment without the 10% penalty, allowing for tax liability to be paid over three years, and a redeposit into an IRA or a qualified plan.

On June 19, in Notice 2020-50, the IRS provided additional guidance:

  • Deemed distributions (“distributions” of outstanding loan balances that occur during continued employment when a loan is in default) do not qualify for the favorable CRD treatment. This means that the 10% premature penalty and income tax would apply. However, loan offsets (“distributions” of outstanding loan balance due to termination of employment) may be treated as a CRD for eligible individuals. Thus “loan offset” distributions are eligible for the favorable tax treatment associated CRDs for individuals who meet the qualifications (no 10% early disbursement penalty, ability to pay tax over three years, and opportunity to recontribute). Employers determine if an offset occurs.
  • The IRS also stated that retirement plans may allow the suspension of loan repayments during the pandemic for impacted participants. This helps avoid a “deemed distribution” with unfavorable tax consequences. This option, however, is not a requirement. If suspended, loan repayments must resume on January 1, 2021, term of the loan should be extended by one year, and payments must be adjusted (re-amortized) to take into account the interest payments deferred, and principal payments not made during the suspension period so that level payments restart for the remaining period of the loan.

Cetera Retirement Plan Specialists is a third-party administrator and may not offer tax, legal or investment advice. Plan sponsors should consult their own tax, legal or investment professionals.