Solo 401k | Individual 401k Loan Default ad Offsets

Loan Default

For a Solo 401k plan loan (participant loan) to be granted an exemption from the IRS’s prohibited transaction rules, loan payments must be made according to a level amortized schedule with payments occurring at least quarterly. When a scheduled loan payment is not made by the end of the quarter in which it is due, the participant solo 401k loan goes into default. At this point, the plan may allow for a “cure period.” This cure period would give the Solo 401k plan participant until the end of the following quarter to catch up on payments.

Causes for Loan Default/ Distribution

A loan becomes a deemed distribution when:

 1) It has not been paid off within the maximum time frame (five years for most loans),

 2) a defaulted loan’s payments have not been caught up to date by the end of the cure period,

 3) a loan exceeds the maximum permissible amount, or

4) an event designated by the solo 401k plan, such as severance from employment, occurs.

Tax Consequences of Loan Default/Deemed Distribution

Even though a defaulted solo 401k loan is reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs Insurance Contracts, etc., for the year in which the loan default (deemed distribution) takes place and normal tax consequences apply (including possible 10 percent early distribution penalty), a loan default/deemed distribution is not an actual distribution for all tax purposes.  Because this is not a true distribution, the defaulted loan cannot be rolled over into an IRA or another retirement plan. Additionally, after a deemed distribution, the loan is still considered a Solo 401k plan asset and may still be repaid. The Solo 401k loan continues to accrue interest, and that balance is used in determining the maximum loan amount available for any subsequent loans.  

Loan Offset Explained

A loan offset occurs when, under the terms of the Solo 401k plan loan, the participant’s accrued benefit is reduced by the amount of the outstanding loan (to “repay” the loan and enforce the plan’s security interest). As opposed to a loan default/deemed distribution, a loan offset is considered a distribution, the loan is no longer part of the plan assets, is not included as an outstanding loan when calculating the maximum loan available for a new loan, and cannot be repaid.

When can a loan be offset?

A defaulted loan can be offset only when there is a distribution trigger available to the participant under the plan. The participant must be eligible to take a distribution. Plans do have the discretion, however, to require loan offsets once a participant has reached a triggering event (e.g., death, disability, severance from employment) even if there has not been a default before the triggering event.

Tax Consequences of a Loan Offset

A loan offset is treated as a distribution for all tax purposes. The distribution is subject to income taxes, as well as any applicable penalty taxes, and is reported on Form1099-R. Provided that the offset takes place before a deemed distribution, it can be rolled over into an IRA or another retirement plan following the normal rollover rules.