What’s a 401k loan offset?

Most companies with an employer-sponsored plan such as 401(k) allow employees to borrow against their accumulated benefits. A 401(k) loan is considered a valuable feature in a 401(k) plan since employees can tap into their retirement savings to pay for college, medical expenses, home improvements, and other expenses. However, 401(k) loans present a problem when an employee leaves the company voluntarily or involuntarily. Usually, if an employee has an unpaid loan, they must promptly repay the loan.

A loan offset occurs when a 401(k) plan reduces your accrued benefits by the outstanding balance of the loan. It is an actual distribution from your 401(k) balance, and it is triggered by a permissible distribution event such as termination of employment, death, disability, or other events provided in the 401(k) loan policy. The loan offset is eligible for rollover, and a participant can delay taxation by rolling over to another 401(k) or IRA.

Tax Consequences of a Loan Offset

A loan offset is considered a distribution for tax purposes. You will owe income taxes on the loan offset amount at your tax bracket rate, and a potential 10% early withdrawal penalty if you are below 59 ½. You must include the loan offset amount in the taxable income for the year in which the distribution occurred. 

You can avoid paying taxes on the 401(k) loan offset by rolling over to an eligible retirement account. Usually, you do not receive new funds for the loan offset; instead, it extinguishes the loan liability from your 401(k) account funds. When rolling over to another retirement account, you must come up with the funds for the rollover. You can get the funds from your other assets, or by using the 401(k) loan proceeds if you have not spent the money.

When can a 401(k) participant rollover the loan offset amount?

Before 2018, the IRS required that plan offsets be rolled over to an IRA or other qualified retirement account within 60 days following the termination of employment. Starting from January 1, 2018, the Tax Cuts and Jobs Act extended the rollover deadline for loan offsets to the federal tax returns deadline for the year when the distribution occurred.

However, the extended deadline only applies to plan loan offset distributions due to severance from employment or plan termination. If a plan loan offset occurs due to other unqualified events, the 60-day deadline still applies.

Deemed distribution vs. loan offset

401(k) loans can trigger two types of distributions i.e. deemed distribution and plan loan offset. Both types of distributions occur when a participant defaults on a 401(k) loan, but they differ in various aspects.

Deemed distribution

A deemed distribution is a distribution that occurs when a borrower defaults on the loan or fails to meet loan requirements. It represents the outstanding 401(k) loan that will be treated as an early distribution, and you will be required to pay federal income taxes. The retirement plan must provide how it handles 401(k) loans default. For example, a 401(k) policy could provide that a 401(k) loan is not considered a deemed distribution until after the end of a calendar quarter following the quarter when the participant defaulted on loan payments.

The participant is taxed as if they received a distribution, but this does not excuse their obligation to pay the outstanding loan balance plus any accrued interests. The missed payments can still be made even after the defaulted loan has become a deemed distribution; the participant can make a lump sum payment to pay off the outstanding loan balance, accrued interests, and the re-amortization of the unpaid balance over the remaining repayment period. Unlike a plan loan offset, a deemed distribution is not an actual distribution, and hence not eligible for rollover distribution.

Plan loan offset

A plan loan offset occurs when the outstanding loan balance reduces your account balance. It can occur when a participant defaults on the loan at a time when they are eligible to take a distribution. For example, a plan loan offset can occur when an employee terminates employment or requests a distribution, and the plan loan terms require treating the loan as in default.

A plan loan offset is an actual distribution, and it can be rolled over to another retirement plan. For example, if you leave your job for another employer, and the new 401(k) plan accepts rollovers, you can transfer the plan loan offset to the new employer’s plan. You can rollover the loan offset by paying the outstanding balance to the old 401(k) or the 401(k) plan receiving the rollover.

How to Report 401(k) Loan Offset

If the plan administrator reduced your 401(k) balance to pay off an outstanding 401(k) loan, you will receive Form 1099-R showing the distribution. The 401(k) plan loan offset should be reported as a normal distribution using code 7 in box 7.