4068 / When is a loan taken under a tax sheltered annuity considered to be a deemed distribution? How does subsequent repayment of the loan, or subsequent failure to repay the loan, impact the participant’s ability to receive additional loans?

The entire amount of a loan will be treated as a distribution from the outset if the terms of the loan do not satisfy the repayment term requirement or the level amortization requirement, or if the loan is not evidenced by an appropriate enforceable agreement.¹

If a loan satisfies the other requirements but the amount loaned exceeds the applicable dollar limitation, the amount of the loan in excess of the limit is a deemed distribution at the time the loan is made.²

If a loan initially satisfies all of the requirements to avoid treatment as a deemed distribution but payments are not made in accordance with the terms of the loan, a deemed distribution of the entire outstanding balance, including accrued interest, generally results at the time of such failure.³

A plan may provide a cure period (referred to as a grace period under the proposed regulations) for payments so long as the cure period does not extend beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due. A failure to make a payment will not trigger a deemed distribution of the outstanding balance until the end of the cure period.⁴

Once a loan is deemed distributed under IRC Section 72(p), the interest that accrues on that loan is not included in income for purposes of determining the amount that is taxable under IRC Section 72. In addition, neither the income that results from the deemed distribution nor the interest that accrues thereafter increases the participant’s investment or tax basis in the contract under IRC Section 72. To the extent the deemed distribution is repaid, his or her investment in the contract will be increased.⁵

A loan that is deemed distributed under IRC Section 72(p), including interest accruing thereafter, and that has not been repaid (such as by a plan loan offset) still is considered outstanding for purposes of determining the maximum amount of any subsequent loans to the participant or the beneficiary.⁶ Thus, for example, the amount limitation would be reduced by an outstanding loan even after a deemed distribution has occurred. To the extent that a participant repays by cash any portion of a loan that has been deemed distributed, the participant acquires a tax basis in the contract in the same manner as if the repayments were after-tax contributions; however, loan repayments are not treated as after-tax contributions for other purposes, including the nondiscrimination requirements and IRC Section 415 limits.⁷

---

Planning Point: The 2017 tax reform legislation modified the treatment of plan loan offsets in certain circumstances. Plan participants with outstanding loans now have until their tax filing deadline (rather than 60 days) to roll the plan loan offset amount into another tax-preferred retirement account and avoid taxation as a deemed distribution, if the amount would be treated as distributed because (1) the plan was terminated or (2) the participant failed to meet the loan repayment terms because of a separation from employment (if the plan provides that the accrued unpaid loan amount must be offset at this time).

---

The final loan regulations place two conditions on loans made while the loan treated as a distribution remains unpaid.

First, the subsequent loan must be repayable under a payroll withholding arrangement enforceable under applicable law. This arrangement may be revocable, but if the participant revokes it, the outstanding balance of the loan is treated as a deemed distribution.

Second, the participant must provide the plan with adequate security in the form of collateral for the loan in addition to the participant’s accrued benefit. If, for any reason, the additional collateral is no longer in force before the subsequent loan is repaid, the outstanding balance of the subsequent loan is treated as a deemed distribution. If these conditions are not satisfied, the entire subsequent loan is treated as a distribution under IRC Section 72(p).⁸

Where a loan fee is withheld from net loan proceeds actually received by a participant but is included in a participant’s outstanding loan balance, the deemed distribution on a default may include the withheld loan fee.⁹