Terminated participant wants to rollover money but has an oustanding loan. Do you withhold on the loan?

[Rai401k]

We have been withholding the 20% on IRA rollovers for participants who have

defaulted on loans.

Example:

Account balance 100,000

Loan 20,000

net 80,000

If the participant wants to rollover the 80,000 and default on the $20,000 loan we

have been rolling over $76,000 and withholdng $4,000 for the defaulted loan.

We have recently been told that is incorrect. Please advise.

[Guest ERISA_kid]

Take a look at IRS Notice 93-3. If the participant defaulted and the outstanding loan balance was previously treated as a deemed distribution, then the 20% withholding shouldn't apply because the deemed distribution is not an eligible rollover distribution. However, if the participant had not defaulted on the loan, but the accrued benefits were offset by the amount of the outstanding loan due to an event such as separation from service, then the offset amount distributed is considered an eligible rollover distribution and the 20% withholding would apply.

[TBob]

I would agree that 20% withholding applies to the portion of the distribution that is taxable (in this case the loan) since it is an eligible rollover distribution but how can you get blood from an turnip?

When a participant elects a rollover of his account less the outstanding loan, he is asking for the cash portion to be rolled over and accepting that the loan will be taxable. If you process his rollover, there will be no cash left in the account to withhold. The 1099R for the loan will show X.XX as taxable with no withholding.

We have always processed this way. This may not be the best approach but I have not seen a cite that tells me that the loan has to be taxed first and therefore the withholding preempts the rollover that he has requested.

[Harwood]

From the 10990-R instructions:

Loans that are treated as deemed distributions or that are actual distributions are subject to Federal income tax withholding. If a distribution occurs after the loan is made, you must withhold only if you distributed cash or property (other than employer securities) at the time of the deemed or actual distribution. See section 72(p), 72(e)(4)(A), and Regulations section 1.72(p)-1.

Employer securities and plan loan offset amounts that are part of an eligible rollover distribution must be included in the amount multiplied by 20%. However, the actual amount to be withheld cannot be more than the sum of the cash and the FMV of property (excluding employer securities and plan loan offset amounts). For example, if the only part of an eligible rollover distribution that is not a direct rollover is employer securities or a plan loan offset amount, no withholding is required. However, any cash that is paid in the distribution must be used to satisfy the withholding on the employer securities or plan loan offset amount.

[Tom Poje]

ERISA Outline Book (2003 edititon, 7.220)

gives some examples.

Adapting to your case:

1.ee could rollover 80,000, no withholding

2.ee could rollover 76,000 and then have 4,000 as a distribution he would never see because it would go for withholding.

either method is fine. In your example you indicated the participant wanted 80,000 rolloed over so method 1 would have been the better method

[rcline46]

I don't think Tom's example works. There is a distribution of 20,000 plus 4,000 or 24,000. Taxes must be withheld at 20% or 4,800 - does not work. Must 'gross up' to get enough cash to cover cash AND loan for taxes. Therefore you need to divide loan by .8 to get total cash for taxes and you get 25,000 with 75,000 for rollover.

However, the correct method is no withholding UNLESS the participant elects otherwise.

[WDIK]

rcline46:

Your point is well taken regarding "grossing up" to the 20% withholding threshhold. But doesn't Tom's example still work because you are withholding all that is available, even though it is only 16.67%?

[Tom Poje]

well, you need to write and tell Sal.......

here is the actual example used.

Balance = 60000

of which 15000 is loan.

so net of loan is 45000

ee rolls over 42000

this leaves a taxable distribution of 18,000 (15000 loan + 3000 additional)

"The non-loan-offset portion is only 3000,

because the 18,000 is reduced by the loan offset.

the total taxable amount is 18,000, or 3600. The non-loan-offset portion is only 3000. [i think something is amiss because the same sentence appears twice!]

The required withholding is 3000 because it is the lesser of the two amounts.

(3000 actual distributed or 3600 taxable)

No cash is distributed because the total cash portion is transmitted for federal income tax withholding."

(There does not appear to be anything about 'grossing' up the distribution in Sal's discussion)

I think the distinction is what you put on the 1099. You would put down 18000 as the distribution, not the 15000 amount of the loan. So net effect being the ee would owe some additional $ at tax time.

[Guest quinn the car fixer]

isn't the key if the loan is deemed distributed or an offset?

I thought the IRS takes the stance that a deemed dist amount is not in the plan for tax purposes ( see 1.72(p) -1 q&a 19)

also "taxation of dist from qualified plans" page 8-57 -- same conclusion