Takeaway: The significant economic tremors, including income insecurity and job reductions, stemming from the coronavirus pandemic may lead to increased loan defaults and impact long-term retirement readiness.
Background: Defined contribution (DC) plans have the option of offering loans to participants. Generally, the participant must repay a plan loan within five years (except for purchases of a primary residence) and must make payments at least quarterly. The plan document (or a separate written loan program) must identify what will happen if a loan repayment is missed, and the circumstances for determining when the loan defaults. IRS regulations specify that if the loan repayments are not made according to the repayment schedule, the entire outstanding balance of the loan is treated as a taxable distribution (“deemed distribution”) and reported on Form 1099-R. Deemed distributions are subject to income tax and may be subject to the 10% early distribution tax.
The plan administrator may (but is not required to) allow a “cure period” in which a missed payment may be made up to prevent the deemed distribution. The cure period cannot continue beyond the last day of the calendar quarter following the quarter in which the required payment was due. For example, if the quarterly payments were due March 31, June 30, September 30, and December 31, and the participant made the March payment but missed the June payment, the loan would be in default as of the end of June, and the loan would be treated as a deemed distribution at the end of September. Note: missed loan payments have to be made by the end of the cure period and cannot be paid as a balloon payment at the end of the loan term.
Participants impacted by COVID-19 may be able to defer repayment and avoid a default. See this post for more information.
Plan sponsors have some ability to facilitate repayments and minimize defaults for participants who are unable to make loan repayments.
- Missed payments: Depending on the terms of the plan, the cure period described above may help participants make up missed payments.
- ACH repayments: For participants who are not terminated but also not receiving a paycheck or enough income to make loan repayments, plan sponsors can offer ACH repayment options.
- Loan repayments for terminated participants: Plan sponsors may require an employee to repay the outstanding balance of a loan if he or she terminates employment or if the plan is terminated. Plan sponsors may support participants by instead allowing them to make repayments following termination.
- Refinancing: Some plans offer the ability to refinance a loan, although generally the term of the loan cannot be extended.
- Impact on new loans: Deemed distributions count against future loan availability. For example, if a participant has a deemed distribution, that counts against the maximum number of loans allowed by the plan. Similarly, if a participant has a deemed distribution of $10,000, that amount counts against the maximum available for any future loans.
Keep in mind that extensions are permitted for participants on leaves of absence:
- Military leave: If the employee is in the armed forces, the employer may suspend the loan repayments during the employee’s active duty and then extend the loan repayment schedule by this period.
- Other leaves: If during a leave of absence from their employer, an employee’s salary is reduced to the point at which it is insufficient to repay the loan, the employer may suspend repayment up to a year. Unlike the exception for active members of the armed forces, the loan repayment period is not extended and the employee may be required to increase the scheduled payment amounts to pay off the loan in the originally scheduled period.
Bottom Line: Loan availability and default provisions are complicated. Plan sponsors should consult with legal counsel on available options and with their recordkeeper on the systems’ flexibility. Additionally, plan sponsors should look to communicate to participants in the event they may be subject to a loan default.
We will continue to monitor any legislative and regulatory guidance and provide updates as the situation evolves.