A “rollover” is when an employee transfers their account balance from one retirement account to another. The advantage of a rollover versus simply taking a distribution is that the participant gets to avoid the mandatory 20% federal withholding, as well as applicable state taxes, and a possible 10% early distribution penalty (if the participant is under age 59 1/2).
Below are answers to some of the most common questions asked by employers about 401(k) rollovers.
How Do I Know If My Plan Provides for the Rollover Opportunity?
By law, all plans are required to permit former participants to elect to roll over distributions.
Does My Plan Have to Accept Rollover Contributions?
No. A plan is not required to accept rollover contributions. This is an election that is made by the Plan Sponsor when designing the plan. The Plan Sponsor may also limit the types of plans from which rollovers are accepted: i.e., from 401(k) plans, 403(b) plans, 457 plans, or IRAs.
What Happens If a Participant Also Has an Outstanding Participant Loan at the Time of Distribution?
Participant loans may not be rolled over to an IRA. In very limited circumstances, participant loans may be rolled over to another qualified retirement plan. For this to happen, the receiving plan must be willing to accept the rollover of the participant loan. If that occurs, the participant continues to make payments on the loan to the new plan.
If a rollover of a loan is not possible, the participant will owe income taxes (and, if they are under age 59½, a 10% additional tax) on the outstanding loan.
There is one other option available to avoid tax: the participant may “repay” the loan to his or her IRA. The participant has until their tax filing deadline to put an amount of money equal to the outstanding loan into an IRA.
Example: Susie takes a distribution from the ABC Company 401(k) Plan on July 1, 2023, and chooses to roll her vested accrued balance to an IRA. At the time of her distribution, Susie owes $4,000 on her participant loan. Susie doesn’t want to pay the taxes on the $4,000 loan offset. If she puts together $4,000 of personal funds by April 15, 2024 (or, if later, her extended tax return due date), she can deposit those funds to an IRA. This will avoid having the $4,000 amount taxed in 2023 and, perhaps even better, she keeps the $4,000 for retirement. Susie must retain the documentation of the payment.
Is There a Reason Why I Should or Should Not Accept Participant Loan Rollovers to Our Plan?
Most employers choose not to accept loan rollovers, mainly because it can be an administrative hassle. You need to obtain and review the loan documentation, have the current loan balance and future amortization information entered into your system, and ensure that your payroll system is properly set up to make the loan payment by payroll deduction each month. If your pay periods are different from those of the prior employer, a new amortization schedule must be created.
However, if you are willing to do this, it will help your new employee avoid current taxation on the loan balance, which may be a great recruiting and retention tool.