Expert: Allen - 8/26/2008

Question
My wife changed employers this year and we just received notice that the 401k loan has been placed into default.

The 401k administrator, was not willing to accept a payment for the amount of the loan.  However, she did recommend that we open a IRA for the amount of the outstanding loan to avoid paying taxes and penalties on the 401k default.

Will the IRS recognize this IRA Contribution as an offset to the 401k default?

Thanks!

Answer
I don't believe the administrator is giving you accurate information.

Check the terms of the loan. Also check the plan's loan policy. You should be able to get copies from the administrator if you can't locate your copies. Most loan policies state that the loan will come due on termination of employment and will be considered in default. However, most allow the participant to pay off the loan so it doesn't go into default.

As far as possible rollover, the administrator may be correct. However, this is tricky. You can not rollover a loan to an IRA. I believe (but am not certain) you can deposit cash instead within 60 days. Look at IRS Publication 575 for the rules. If this is acceptable, the administrator will issue a 1099 next January for the unpaid balance. You will then have to explain to the IRS why no tax is due. In any event, I would try to avoid this by paying off the loan.