When a participant terminates employment, what happens to their loan balance?

Most plans provide that the loan becomes payable in full upon termination of employment. If the loan is not repaid within a specified amount of time, the loan is “offset”. What this means is the outstanding loan balance is treated as being distributed from the plan to the participant.

A plan can, however, permit a participant to continue to make regularly scheduled loan payments after termination employment, so you will want to check the plan document and loan policy to determine which provisions apply.

Is a loan that has been offset taxed?

A loan that has been offset (which is an actual distribution) is taxable to the participant. Further, it is subject to the 10% early withdrawal penalty unless an exception applies.

To avoid taxation, a participant can rollover the dollar amount of the loan balance that was offset to an IRA or other qualified plan (assuming the plan accepts such rollovers).

How long does a participant have to complete the rollover?

Effective January 1, 2018, a participant has until the extended due date of his or her individual income tax return (for the year the loan was offset) to complete the rollover.

It is important to note this extended rollover period only applies to the loan offset amount; the normal 60-day rollover window applies to any cash distributions.

Is the loan offset amount subject to 20% federal withholding?

It depends. If the participant receives a cash distribution, the outstanding loan balance is included when determining the 20% withholding requirement. If the participant doesn’t take a cash distribution, then withholding would not apply.

Can a participant rollover their actual loan balance to another employer’s plan?

Possibly. Assuming the loan has not been offset, it would be permissible to rollover the loan itself from one plan to another if permitted under the terms of both plans. However, this is not a very common feature.

What if a plan is terminated?

Generally, the rules described above also apply when a plan is terminated.

How can I learn more?

If you would like to learn more about these rules, please contact us.