I changed jobs recently, not of my own volition. I'm now rolling over a 401k account with my previous employer to one with my current employer. Three years ago I took a 401k loan with a 10 year term which was used to purchase a home. It's now technically in default, since payments are no longer being deducted from payroll.

My understanding that the loan will be formally "in default", though no credit rating damage will occur, and that the disbursement is taxable. Can I reduce (or eliminate) the tax penalty by making an equivalent contribution to my new employer's 401k (or one of my other retirement accounts) this year? If not, what other options might I have? My current employer doesn't allow 401k loans, so that's not possible.

Update: I'm not able to pay off part of the loan balance. It's all or nothing according to the fine print, and unless I borrow part of it that won't happen.

  • Short answer: No. The 401(k) plans are unrelated. – Dilip Sarwate Nov 13 '18 at 20:00
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    Where would the 401(k) contribution come from? If you can contribute to your new 401(k), why wouldn't you just pay off the 401(k) loan? – D Stanley Nov 13 '18 at 20:01
  • I wouldn't be able to pay off the entire loan. Roughly half of it. – isherwood Nov 13 '18 at 20:01
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    So pay half of it, then you're only liable for tax on the other half. Yes you can offset with deductions but seems simpler just to pay the loan (and avoid penalties). And never ever borrow from your 401(k) again. – D Stanley Nov 13 '18 at 20:19
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    You are best served speaking with the 401K administrator of the previous company. While there are laws surrounding this, there are also rules imposed by the individual administrators that can be more strict. Talking with them will help you navigate your options. – Pete B. Nov 13 '18 at 20:22

Talk to your previous employer and get the exact deadline. Then throw as much money at the loan before the deadline. The more you pay the smaller the penalty and the greater amount you will have available for your retirement.

The amount you don't pay back hurts your nest egg. The larger the penalty you pay in April the harder it will be to contribute enough in 2019.

Money contributed with the new 401k doesn't reduce the penalty.

  • Thank you. That answers my question. I've learned that partial payoff is not an option according to the plan policy. I'll be taking the tax hit and keep my rainy day fund, which would have gone to the partial payoff. – isherwood Nov 13 '18 at 20:40
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    Also ! Try to get a loan to pay off the rest. The tax hit on the 401(k) loan is far greater than any interest you'll pay to a bank. – xyious Nov 15 '18 at 16:21

You can reduce the penalty by contributing part or all of the defaulted amount to an IRA before April of next year (or potentially October of next year). Although a default on your 401(k) loan is treated as a withdrawal, it will not be considered a withdrawal if you "rollover" the "withdrawal" into an IRA or to a new 401(k) plan; i.e. if you deposit the amount of the 401(k) loan you defaulted on into an IRA or your new company's 401(k). Normally, you can only make this "rollover" contribution to the IRA within 60 days of the "withdrawal" (unless the government grants you a hardship exception). However, in the 2018 and later tax years, in the case where the loan default was caused by you leaving work, you have until the tax filing deadline, including extensions (October 15 of the following year, if you have an extension; April 15 if you don't have an extension), to make this rollover.

This is described in Publication 590-A, section Time Limit for Making a Rollover Contribution:

For distributions made in tax years beginning after December 31, 2017, you have until the due date (including extensions) for your tax return for the tax year in which the offset occurs to roll over a qualified plan loan offset amount. A “qualified plan loan offset amount” is the amount your employer plan account balance is reduced, or offset, to repay a loan from the plan. The offset must be because either the plan terminated or you severed your employment with the employer.

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