What Should be Done with a Loan When a Participant Terminates Employment?

When a participant requests a retirement plan loan, they receive a sum of money from their retirement plan balance – tax free. However, in order to shelter these dollars from taxation, they must repay these funds by the maturity date (generally five years from the date of the loan). Most plans require payment through payroll deduction and repayment upon termination.

When an employee terminates service with an outstanding loan balance, the loan should be offset from the recordkeeping books. Because the participant received these dollars tax free previously, the offset now creates a taxable event for the participant. The Internal Revenue Service requires the unpaid balance be reported on the 1099-R as taxable income to the participant.

TSC recommends the following approach when a participant terminates service with an outstanding loan balance:

  • Check the loan policy in your Summary Plan Description to determine whether a loan would be offset upon termination of employment.
  • If a loan is required to be offset, contact your service provider with the participant termination date.
  • Notify the participant of the outstanding loan dollar amount. Participants may avoid taxation of these funds by repaying the loan balance or rolling it over to another eligible employer sponsored retirement plan. 

Lisa Melberg, Plan Document and Compliance Specialist