IRS Updates the Special Tax Notice (Rollover Notice) for Qualified Plans
Qualified plans are required to provide participants with a number of notices and information. There’s the Summary Plan Description, the Summary Annual Report, annual safe harbor notices (if applicable), plan account statements (either quarterly or annually), and the Special Tax Notice for distributions. The timing for these notices varies, with some being issued annually and others only upon the occurrence of a specific event. This week, the IRS released new guidance updating the Special Tax Notice to include, among other things, changes enacted by the Tax Cuts and Jobs Act.
The Special Tax Notice, also called a Rollover Notice or 402(f) Notice, must be furnished to plan participants any time all or a part of a distribution is eligible for rollover. That means the Notice doesn’t have to be provided until the participant elects a distribution. Usually, it is included along with the distribution form. While the Tax Code allows plans to create their own Special Tax Notice (by following IRS guidelines) the IRS has also issued two safe harbor notices that plans can adopt. One is for payments from a Roth account within a plan (e.g., Roth 401(k), 403(b), or 457(b)) and the other for all other non-Roth plan accounts. As you may suspect, most plans adopt the safe harbor notices.
While the Tax Cuts and Jobs Act didn’t have too great of an impact on qualified plans, it did change the rollover rules for plan loan offsets. Under the Act, the rollover period was extended for plan loan offsets that were due to a termination of service or a plan termination. Instead of the normal 60-day rollover period, the new law extends the period until the individual’s tax return due date, including extensions, for the year in which the offset took place. The updated safe harbor notices provide additional information on this new rule.
A plan loan offset occurs when the outstanding balance of a loan is accelerated upon an event stated in the plan. The most common occurrence is termination of service. Under many plans, that means outstanding plan loans become immediately due if the employee separates from service with the employer. The outstanding balance may be immediately offset against the current plan balance with the employee receiving an IRS Form 1099-R at the end of the year for the amount of the offset. Offsets can be rolled over. Since the employee doesn’t receive any actual payment from the offset, he or she must use other funds to complete the rollover.
For example, let’s say Beatrice took an $8,000 loan from her 401(k) plan in 2015. After repaying $6,000 of the amount, she resigns from her position to work for another unrelated company effective March 6, 2018. When she leaves her previous employer, her outstanding loan balance is $2,000. Beatrice’s plan will probably require the $2,000 to be immediately due. It may give her the opportunity to choose between paying off the loan or accepting the offset. However, the plan could also simply assess the offset. Beatrice’s plan automatically offsets her 401(k) plan balance by the $2,000 outstanding loan balance. Since the offset occurred because Beatrice terminated employment, not only can she roll over all or a portion of the offset, but she also has the extended timeframe. In this example, Beatrice has until the due date for her 2018 tax return, plus extensions, to execute the rollover. Whatever amount Beatrice doesn’t roll over will be subject to income tax and the early distribution penalty (if applicable).
This rollover treatment does not apply to defaulted loans. If an employee stops paying on a loan, the unpaid amount becomes subject to tax and potentially the early distribution penalty. The Tax Code calls this a “deemed distribution.” There are other potential deemed distributions, such as a loan that exceeds the maximum loan limit. In any event, these “distributions” can never be rolled over.
Finally, the new safe harbor Special Tax Notices include other recent legislative updates. There is information related to self-certification (e.g., late 60-day rollovers) and exceptions to the 10% early distribution penalty (public safety employee exception and phased retirement distributions for some federal retirees).
Plan sponsors will want to update their current distribution package to include the new Notices. Fortunately, this isn’t a monumental task. The new IRS guidance in Notice 2018-74 includes the revised model notices along with highlighted changes.