4065 / What is the substantially level amortization requirement applicable to a loan taken under a tax sheltered annuity that seeks to avoid taxation as a deemed distribution?

To avoid treatment as a deemed distribution, a loan generally must provide for substantially level amortization over the term of the loan with loan repayments to be made at least quarterly.¹ The level amortization requirement does not apply, and payments may be suspended, for a period up to one year while a participant is on a leave of absence and the participant’s pay from his or her employer is insufficient to service the debt; a participant taking advantage of a suspension still must repay the loan by the latest permissible term of the loan and the installments due after payments resume must be at least as great as those required under the terms of the original loan. The latest permissible term of the loan is the latest date permitted under IRC Section 72(p)(2)(B), that is, five years from the date of the loan subject to the exception for principal residence loans, plus any additional period of suspension permitted under a military service leave.²

With respect to a leave of absence due to military service, IRC Section 414(u)(4) allows a participant to suspend repayment of a loan during any period that he or she serves in the uniformed services. The suspension of repayment under these circumstances may extend beyond one year, unlike the suspension rules for other leaves of absence.

A participant must resume loan repayments once he or she completes military service, at which time payments must be made as frequently and in an amount no less than was made before the suspension. The full amount of the loan, including interest accrued during the suspension, must be repaid by the end of the latest permissible loan term.

The latest permissible loan term under these circumstances is the latest permissible date under IRC Section 72(p)(2)(B), that is, five years from the date of the loan, subject to the exception for principal residence loans, plus any additional period of suspension permitted for military service. For example, if a military reservist obtained a three year loan and then served two years on active duty, the officer would have up to seven years to repay the loan, calculated as the five year maximum permissible loan term plus the two year suspension period. An example in the regulations illustrates the application of a 6 percent interest rate cap under the Soldier’s and Sailor’s Civil Relief Act Amendments of 1942 on a reservist’s monthly installments and payment period.³

Failure to make any installment payment when due generally results in a deemed distribution of the entire outstanding balance of the loan at the time of such failure. A plan may provide a cure period 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. The cure period was referred to as a grace period under the proposed regulations.⁴