Deemed Distribution vs. Loan Offset: What’s the Difference?
An unpaid retirement loan can be a taxable event or an actual distribution. Understand the critical distinctions between a deemed distribution and a loan offset.
Loans from retirement plans like 401(k)s are a common feature, but participants must understand the consequences of failing to repay them. When a loan is not repaid, two distinct events can occur: a deemed distribution or a loan offset. While both involve an outstanding loan balance, their triggers, tax treatment, and subsequent options are different.
Understanding Deemed Distributions
A deemed distribution is a taxable event triggered by a failure to adhere to the loan’s terms. The outstanding loan balance is treated as a distribution for tax purposes, even though no money is actually removed from the account. This happens when a participant misses loan payments and fails to correct the issue within a grace period, which generally extends to the end of the calendar quarter following the missed payment. Other triggers include violating the loan’s structural requirements, such as a repayment term exceeding five years, unless the loan is for a primary residence.
The tax consequences are immediate. The entire outstanding loan balance is considered ordinary income for the tax year in which the default occurs. If the participant is under age 59 ½, the amount is also subject to a 10% early withdrawal penalty. The participant is responsible for paying the associated taxes.
A deemed distribution is not an actual distribution of funds. The loan note remains an asset of the plan, and the participant is still legally obligated to repay the loan with accruing interest. The original loan principal that was deemed distributed is now treated as after-tax money in the account.
Because the defaulted loan is still considered outstanding, the participant may be unable to take another loan from the plan until the full amount is repaid or a loan offset occurs.
Understanding Loan Offsets
A loan offset is an actual reduction of a participant’s vested account balance to repay an outstanding loan. Unlike a deemed distribution, an offset is a true distribution of plan assets that extinguishes the loan and the repayment obligation.
The primary trigger for a loan offset is a distributable event, with the most common being a participant’s separation from service. When an employee leaves their job and cannot repay the loan in full, the plan will offset the account balance to cover the debt. Other distributable events include the termination of the 401(k) plan or the participant reaching an age where in-service distributions are permitted, such as 59 ½.
The tax consequences of a loan offset are the same as any other retirement plan distribution. The offset amount is included in the participant’s gross income and is subject to ordinary income tax. If the participant is under age 59 ½, the 10% early withdrawal penalty will also be assessed.
A loan offset can happen to a loan that is in good standing, such as when a participant leaves their job. An offset can also occur after a loan has been deemed distributed, but this second event is not newly taxable.
Key Differences in Tax Reporting and Rollover Options
A deemed distribution is not an actual distribution and, therefore, is not eligible for rollover. The participant cannot move the deemed amount into an IRA or another qualified plan to defer taxation, and the tax liability is immediate. In contrast, a loan offset is an actual distribution and is eligible for rollover.
To complete the rollover, the participant must use external funds, such as personal savings, to deposit an amount equal to the offset into an eligible retirement plan, generally within 60 days of the offset.
Qualified Plan Loan Offset (QPLO)
The Tax Cuts and Jobs Act of 2017 created a special provision for certain loan offsets, known as a Qualified Plan Loan Offset (QPLO). A QPLO is a loan offset that occurs solely because of either the termination of the 401(k) plan or the employee’s severance from employment. This rule extends the time a participant has to complete a rollover from the standard 60-day window to their federal income tax filing deadline for that year, including extensions.
Tax Reporting
The distinction between these events is reflected on IRS Form 1099-R. A deemed distribution is reported with Code ‘L’ in box 7, which signifies a loan treated as a distribution. A loan offset, being an actual distribution, is reported with a standard distribution code. For example, it might be Code ‘1’ if the participant is under 59 ½ or Code ‘7’ for a normal distribution if the participant is over 59 ½.