Is it possible to avoid tax penalties on a 401k loan default by opening an IRA for the same amount as the outstanding loan balance?

[ccounceller]

Got caught in a lay-off, transferred the 401k funds to my new employer.  Got advice from an IRA guy that taking a new loan on the 401k and opening an IRA in the same amount of the loan will solve the problem.  Is this likely to work or am I better off paying off the original 401k loan?

No more loans after this.
Chris.

[dmertz · Accepted solution]

The answer depends on whether you received a deemed distribution of the loan amount (typically the result if the loan was in default at the time of the distribution rolled over to the new employer's plan) or you received an offset distribution where your received a distribution of the full 401(k) but a portion of that distribution was used to pay back a loan that was still current (or within the grace period).

A deemed distribution is not eligible for rollover.  However, the amount used to repay the loan with an offset distribution is eligible for rollover if you can come up with that amount (perhaps a loan from the new plan) and complete the rollover within 60 days of the offset distribution.  The rollover of the offset amount can be to an IRA or to your new employer's 401(k) and will continue to defer the income, thus avoiding any tax or early distribution penalty.  Note, however, that if you received an offset distribution, some amount will have been required to have been withheld for taxes, so that will need to be included in the amount that you have to come up with to complete the entire rollover.

You'll need to contact your old employer's plan to find out if you received a deemed distribution or an offset distribution.

[Critter1]

To make the 401K transfer to the new employer the entire balance needs to move to avoid any tax and penalties. You will need to pay off that loan within the window given and definitely before you roll the balance. Any loan amounts not paid are considered distributions and are subject to tax and penalties if you are under the age of 59.5 .  

So to the IRA contribution idea... if you are not going to pay the loan off and you are not subject to the penalty then you may be able to contribute to a Traditional IRA subject to contribution limits and deductible limitations.