Blog
January 9, 2018
Big Surprise! New Tax Law Leaves Retirement Plans Primarily Unscathed!
The new tax law passed recently surprised many of us involved in the creation of retirement plans, as only a few changes apply or will actually affect retirement plans in the end. This was a bit of a pleasant shock because when it comes to government debt reduction, retirement plans have always been firmly on the chopping block.
Although the changes in this area are minimal, there are a couple of key revisions you need to know. The most notable new provision is one that allows participants, with a loan outstanding upon employment termination, more time to roll it over and avoid current taxation. There is also a new rule that does not allow re-characterization of rollovers, after plan participants have made their plan elections, and the other is new, special rules for disaster victims.
Extension of Time to Roll Over Participant Loans
Under current rules, if you have an outstanding participant loan and you terminate employment, your distribution will be offset by your loan. When this happens, you are taxed on the value of the loan. You could also be taxed on the outstanding loan, because your payments on the loan cease when you stop receiving a pay check. Either way, you are taxed on the loan balance, which is called an “offset.”
Here’s a hypothetical example:
Jane Doe has an account in her employer’s 401(k) plan worth $30,000. She also has a participant loan from the plan of $10,000. Jane terminates her employment with the employer and she requests a distribution of her benefit under the plan. The plan offsets the $10,000 amount Jane has borrowed against the 401(k) account, and pays Jane the balance of $20,000. Jane is then taxed, however, on the full $30,000, as the loan forgiveness is taxable income. If Jane rolls over the cash part of her distribution, and in this case $20,000, Jane will still be taxed on the $10,000 loan offset.
How to Avoid This Taxation
Using the hypothetical scenario above, there are two options Jane has to avoid this type of taxation.
Option One: Jane can repay the loan to the plan before her distribution occurs, permitting the plan to pay her the full $30,000 amount. Then she can roll over the total to an IRA or other plan.
Option Two: The second option is Janice may receive the $20,000 net amount from the plan, add $10,000 of her own assets to the amount, and roll over the $30,000 taxable distribution (from the plan to an IRA or another employer’s plan). Under current law, Jane has only 60 days from the date on which the loan is offset to do this, and that is often too little time for a participant to come up with the money to make this happen.
The new law gives Jane more time to come up with needed funds. A participant who “receives” a loan offset will have until his or her tax return due date (including extensions for the year and during which the loan offset occurred), to roll over the taxable amount of the borrowed funds to an IRA or other employer plan. So, if Jane experienced the loan offset sometime during 2018, she would have until her tax return due date of April 15, 2019 (or, if she extended her return, until October 15, 2019), to deposit the offset funds to an IRA or other employer plan.
This extension of time is available only if the loan becomes taxable due to a termination of employment; or a termination of the plan and not because the participant had defaulted on the loan repayment while employed.
Denial of Re-characterization of Roth Contributions and Rollover
Under the current rules, if you make a contribution to a normal IRA and decide that you really intended it to be a Roth IRA (or vice versa), you may ask the trustee of your IRA to transfer the funds to the trustee of the other type of IRA. If you do this before your tax return due date, it is treated as if you made the initial contribution to the plan that the money ends up in the end. Under old law, this recharacterization ability applied to a rollover and conversion of pretax money to a Roth. Note: You must pay taxes on the amount moved to the Roth account in the year of conversion.
Under the new rules, you cannot reclassify a conversion rollover once it has occurred. This means that, if you moved money from a conventional IRA or a pretax plan account to a Roth IRA in 2017, and you were planning to reevaluate the decision by October 15, 2018, your deadline to complete the recharacterization is now December 31, 2017. You would not be able to recharacterize rollover amounts after this year.
Relief for distributions made before January 1, 2018
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Distributions are not subject to mandatory withholding or the 10% premature distribution penalty.
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Distributions are permitted even if such distribution would normally be prohibited under the Code’s Operational Rules (e.g., 401(k) money that is normally not eligible for in-service distributions prior to age 59½). Amendments to permit this may be adopted after the fact, but must happen before the end of the plan’s 2018 year.
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The income tax bite on the distribution may be spread over three years, rather than totally payable in the year of distribution.
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The amount distributed (or a lesser amount) may be deposited within three years of the date of the distribution to an IRA, qualified plan, 403(b) plan; or 457(b) plan, in which case it is treated as a nontaxable rollover to the recipient plan. In other words, no tax will be due on the amount that was distributed and then re-contributed.