Defaulting 401(k) Plan Borrowers in the Time of COVID

Daniel L. Morgan

The great majority of 401(k) plans allow participants to borrow against their plan benefits. These loans are secured by the borrowing participant’s plan account and are typically repaid by withholding amounts from the borrower’s paychecks.

Plan loans are subject to a number of limitations, including a repayment period of five years (unless the loan is used to acquire a primary residence) and a maximum borrowing limit of 50 percent of the borrower’s vested account balance or $50,000.* Violating these limits has adverse tax consequences to the borrower, which are not addressed in this article. The focus of this piece is what happens when someone has borrowed from a 401(k) plan within the limits, terminates employment, and then defaults on the loan—in particular, changes made by the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and a 2017 change to the tax law, which are helpful to the large number of people who may find themselves in this situation during the pandemic.

Plan Loan Defaults by Terminated Employees = Plan Distributions

Under most 401(k) plans, borrowers who terminate employment before paying off their plan loan must either pay the entire remaining amount of the loan within a period of time specified by the plan after cessation of employment or, failing to do so, be considered to be in default on the loan, in which event the tax law treats the borrower as having received a distribution from the plan in the amount of the unpaid loan balance. The Internal Revenue Service (“IRS”) refers to this amount as a plan offset amount.

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