Does a 2020 retirement plan offset qualify for special 2020 COVID-19 retirement rules?

Question of the Week 3/31/21: Two clients had outstanding 401(k) loans when they lost their jobs due to COVID-19. Will they qualify for the 2020 retirement plan loan offset rules?

April 05, 2021

Q. Does a 2020 retirement plan offset qualify for special 2020 COVID-19 retirement rules?

Two clients had outstanding 401(k) loans when their companies downsized last year because of COVID-19 and they lost their jobs. Both were given a short time frame to repay their balance and did not do so. Both rolled over their 401(k) balances directly to IRAs and didn’t take any other distributions. Evelyn received a 1099-R with a distribution code of L for a loan treated as a distribution. Phil’s 1099-R has a distribution code of M for a qualified plan loan offset. What is the difference between the two codes? Can the 1099-R amounts be treated as coronavirus-related distributions?

A. A qualified plan loan offset is eligible for special 2020 COVID-19 retirement rules, but a deemed distribution is not.

Both clients appear to be qualified individuals for 2020 COVID-19 related distributions because they experienced adverse financial consequences, i.e. lost their jobs due to coronavirus-related circumstances. However, only Phil can treat his distribution as a qualified 2020 disaster distribution.

1099-R code L represents a deemed distribution ineligible for special 2020 COVID-19 retirement rules

Since Evelyn did not repay her outstanding loan, the balance is treated as a deemed distribution from her 401(k). As such, it is treated as any other distribution. It is subject to tax and, if Evelyn is under age 59 ½, it is subject to the 10% additional tax unless an exception applies.

A deemed distribution of a plan loan is not eligible for qualified disaster distribution treatment. See “Distributions that are not qualified 2020 disaster distributions” in the instructions to Form 8915-E, Qualified 2020 Disaster Retirement Plan Distributions and Repayments.

1099-R code M represents a qualified plan loan offset eligible for special 2020 COVID-19 retirement rules

A plan loan offset means that the plan participant’s account balance is reduced to repay the outstanding loan. The offset is an actual distribution rather than a deemed distribution. A qualified plan loan offset often occurs when an employer plan is terminated or a loan is not repaid because the participant is no longer employed by the plan sponsor, which was apparently the case for Phil.

Plan loan offsets, including qualified plan loan offsets, are eligible for qualified disaster distribution treatment including special 2020 COVID-19 rules. Phil reports his coronavirus-related distribution on Form 8915-E. See “Types of qualified disaster distributions” in the instructions.

Phil has the option of spreading the tax on the distribution over three years and he can recontribute some or all of the distribution during this period. Also, regardless of his age, the distribution is not subject to the 10% additional tax. Since his 401(k) account is closed, Phil can recontribute the distribution to an IRA or another qualified retirement plan that accepts his recontribution.

Although Evelyn’s and Phil’s circumstances seem to be very similar, it could be that Phil’s 401(k) plan, or the terms of his plan loan, or the terms of his employment separation were different from Evelyn’s. Phil will benefit from the special treatment for his 401(k) distribution and Evelyn will not.

Note that if Phil’s distribution was not a qualified disaster distribution, for example, if he had received it in 2019 and was not affected by a federal disaster declaration, the distribution would have been subject to tax and the 10% additional tax. However, tax and penalty may be avoided if the distribution is recontributed, generally within 60 days. See “plan loan offset” on p. 29 of IRS Pub. 575, Pension and Annuity Income. In contrast, a deemed distribution is not eligible for rollover.

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