If I am 58 have a 401k loan and get laid off is there a 10% penalty? Or does the rule of 55 preclude the penalty?

[DanaB]

Yes, the exception of Separation from Service should apply in your case. Distributions made to you after you separated from service with your employer qualify for an exception for the 10% penalty if the separation occurred in or after the year you reached age 55. (IRS Exceptions to Tax on Early Distributions)

[SweetieJean]

I thought the rules were different for a loan default.

[SweetieJean]

@dmertz

[dmertz]

The answer is correct.  Upon separation from service the loan would normally be paid off with an offset distribution and there would be no default.  If the offset distribution is not rolled over, it's taxed just like any normal distribution.  Since separation from service occurred after age 55, the age-55 penalty exception would apply.  The Form 1099-R for this distribution *should* have codes 2 and M, indicating no penalty and that the distribution is not subject to penalty and, should one be able to come up with the money, the amount is eligible for rollover to be able to continue to defer taxes.  Sometimes the payer mistakenly uses code 1 instead of code 2 in this situation, so the age-55 penalty exception would have to be explicitly claimed on line 2 of Form 5329.

If the offset distribution is rolled over to an IRA, subsequent distributions from the IRA made before age 59½ would be subject to income tax and penalty, so one should be careful not to complete the rollover using money that one might expect to need before age 59½.