401k loan was paid off with an early disbursement. Now they're saying the only way to avoid taxes/penalty is an indirect rollover.

[Erikull]

I had a 401k loan taken out last year and was laid off two months later. In my severance package, I was told I could maintain payments and it would be fine. I had been doing so for six months until suddenly, the balance was withdrawn from my 401k to pay the loan off. 

I asked Vanguard who said I needed to contact them to set up a payment plan before the quarter after the quarter I was terminated, which I was not aware of. They said I am subject to taxes and penalties next tax season, but I may be able to avoid this with an indirect rollover. They wouldn't talk to me anymore about it and suggested I seek a tax advisor.

From what I understand, an indirect rollover is basically just be loading money into an retirement account. If I just put the funds into any retirement account before next tax season (that's the time frame they gave me), will I avoid the taxes and penalties?  Does it have to go into the same account? I don't know if I can even put more funds into that account. Do I need to complete any forms as I deposit it so it's accounted for as paying back that disbursement?

Thanks ahead of time

[macuser_22]

If you receive a 1099-R with a code M in box 7 then the box 1 amount will be taxable income to you unless you can replace that money with other funds and roll it into a Traditional IRA before the due date (including extensions) of the tax return for the year on the 1099-R.     You must instruct the IRA custodian that this is a 1099-R code M rollover for them to allow the contribution.

[Opus 17 · Accepted solution]

Basically, you need to find an equal amount of money to the deemed distribution that you can deposit into an IRA or into a 401(k) at a new place of work, within 60 days of the distribution date.  If you can do that, you would tell the custodian of the new plan that this is a rollover.  Then, you would not owe tax and a 10% early withdrawal penalty on the distribution amount.  If you can borrow the money at a decent interest rate, you will probably come out ahead in the long run by taking out a private loan that will allow you to deposit the distribution amount into a new account and call it a rollover.

[Erikull]

Okay great, that's exactly the info I'm looking for.  I just started a new 401k with a new employer. If I put the same amount in there, I just need to let my new place know it's a rollover? Do you know if I have to tell the last 401k holder anything or complete a tax form or something? 

Thank you again!

[Erikull]

Perfect! Vanguard did say they would provide a 1099-R. I knew there had to be somewhere I indicated this would be accounted as a contribution to make up for the loan offset. Thanks so much!

Any by the IRA holder, you mean the holder of the new IRA I am putting the funds into, or the ones who offset the loan, Vanguard?

[Opus 17]

You must tell the custodian of the new account that this is a rollover of an offset distribution.  They may have a special form you must fill out. In fact, a 401(k) can’t accept a check out of the blue from you so you must contact them ahead of time.  

The trustee of the new 401(k) is not required to accept rollovers, although most do.  If they don’t, you would need to open a private IRA instead.  

I said 60 days but that is a general rule; in the case of what is called an “offset distribution” due to an outstanding loan, the deadline is as @macuser_22  says, which is your tax deadline for the year the offset distribution occurred.  

I presume you still have a cash balance left at the old 401(k)?  (Did they just offset the loan or close the account and send you the rest?)  You could, of course, transfer all your remaining money to the new plan as well.  But you can only do 1 rollover per year.  You could transfer the rest of the money by direct plan to plan transfer, there is no limit on direct transfers. 

The old plan already has the information they need to issue a 1099-R.  

[dmertz]

The one-rollover-per-year limit only applies to IRA-to-IRA rollovers, not to any rollover involving a 401(k).  However, you still want to do a rollover from one 401(k) to either another 401(k) or to an IRA by direct rollover to avoid mandatory 20% tax withholding on any amount otherwise paid to you personally from a 401(k).

[Erikull]

@Opus 17 Opus, I could kiss you! Thanks again for all this info, it's such a relief. I'll be contacting my new 401k holder about how to make a contribution and be sure it counts as a rollover. 

Cheers!

[Erikull]

@dmertz Good to know! Thank you so much!!

[dmertz]

If you roll the offset distribution over to the 401(k) at your new employer, you'll need to provide explanation with your tax return for the year of the offset distribution since 401(k) plans that receive rollovers do not provide anything to the IRS that documents receipt of a rollover contribution.  If the rollover is instead to an IRA, the IRA custodian will report on Form 5498 the receipt of the rollover contribution, so no separate explanation would be needed.

[Erikull]

Ah okay. I figured there would be a place to indicate it. Will there be anywhere on TurboTax to indicate it, or do I need to include a separate explanation somehow?

[dmertz]

You're tax return will simply show it as a "ROLLOVER."  TurboTax will not prompt you to enter any explanation statement, so you would need to prepare that separately and include it with your mailed tax return.  It's relatively common for the IRS to question an ordinary indirect rollover to a 401(k), so it seems even more likely that, without an explanation, the IRS would question a rollover to a 401(k) of an offset distribution given that no cash is actually distributed in an offset distribution.

[Opus 17]

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@dmertz wrote:

You're tax return will simply show it as a "ROLLOVER."  TurboTax will not prompt you to enter any explanation statement, so you would need to prepare that separately and include it with your mailed tax return.  It's relatively common for the IRS to question an ordinary indirect rollover to a 401(k), so it seems even more likely that, without an explanation, the IRS would question a rollover to a 401(k) of an offset distribution given that no cash is actually distributed in an offset distribution.

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At the present time, the IRS does not allow PDFs to be attached to a tax return when you need to attach a written explanation of something, so you would have to mail your return.  However, check back next year because it's always possible this is something that will be added.

[Erikull]

Good to know. I'll make sure I print it instead of e-filing (unless things have changed next year). Thanks for this!