Converting 401k with loans to IRA
When a 401k has outstanding loans, how does that affect converting to an IRA? Example: a friend was recently layed off from his employer and has a 401K balance of 20,000 with outstanding loans with a balance of $2,100. Incidentally, he is 40 years old and my need to take 72t payments to make ends meet while looking for another job. If he converts the 401k to an IRA, do the loans have to be paid back prior to the conversion? If not, will the conversion to IRA automatically cause the loans to become taxable?
Thanks,
Permalink Submitted by Alan Spross on Mon, 2009-03-02 23:25
If he was not formerly in default which caused a deemed distribution, then his separation from service becomes a distributable event. This means that the amount of the loan could either be repaid within a certain plan time limit before ordering a direct rollover OR
the plan would offset the loan in an offset distribution. This would probably result in doing a direct rollover of the remaining balance and the loan balance could be replaced with a rollover to the IRA, but he would have to come up with the loan balance to complete that rollover. If not, the amount of the loan will be taxable and subject to early withdrawal penalty. This should all be confirmed with the plan administrator prior to acting.
In addition, starting a 72t plan at 40 is not a good idea, because the plan must last for 20 years and if it is ever busted, retroactive penalties and interest will be due back to the first year of distributions. So if he intends to work again, he would be better off just paying the penalty or possibly offset some of the penalty with other exceptions, such as health insurance or medical expense exceptions.
Permalink Submitted by Joseph Arsenault on Wed, 2009-03-25 18:38
Alan,
If someone transfers their 401k balance to a TIRA and they have a small portion in a loan they cant cover. To clarify what your saying, they still have 60 days to make up that loan portion and rollover the balance “in whole” and avoid taxation. Is that correct?
Permalink Submitted by Alan Spross on Wed, 2009-03-25 21:53
Yes, if the loan is offset, and then the 1099R will appear as a normal 1099R and the full amount is rollover eligible. If a code “L” appears for a deemed distribution OR was issued for a prior deemed distribution, then those amounts are NOT eligible for rollover.
This article attempts to explain the difference:
http://www.relius.net/News/TechnicalUpdates.aspx?ID=262