401k loan default and indirect rollover
I have a client under 59 1/2 that left his job with a balance on a loan. He rolled over the balance to his new employer plan as a direct rollover. The previous employer forced a default of the loan on the day the distribution was made and will not allow him to pay back the loan directly to the old plan.
Due to a serious medical issue the client does not have the funds to pay off the loan (and why he left his old employer in the first place.) Because he has rolled over the funds, defaulted, and has no cash on hand my suggestion was to offer the potential to for avoiding the taxes on the default and possibly payoff everything as he can afford it knowing he could simply place himself in the same position anyway. Am I right in that because the new plan offers a loan provision of 50% the he, if he can get the loan from the new companies 401k, he could take out a loan and use the funds to make a full indirect rollover to an IRA for the amount of the default and any taxes/penalties to offset the expected 1099. The new loan and indirect rollover would occur within 60 days of the default of the previous loan. In essense, this would avoid the tax and do a roundabout transfer of the loan from one comapny plan to another.
Can an indirect rollover be used this way to offset a defaulted 401k loan?
Thanks for any responses. I know this may not solve the problem but it may at least delay it.
Permalink Submitted by Alan Spross on Thu, 2011-04-21 22:16
That would probably work as long as the former employer does NOT issue a 1099R for a deemed distribution of the loan, and under these circumstances I doubt that they would. Any deemed distribution is not rollover eligible. But an offset distribution can be rolled over by replacing the funds in an indirect rollover.
If he can get the new 401k loan, his contributions may be limited, but he may not care of about that under the circumstances.
Permalink Submitted by Matthew McDonald on Wed, 2011-07-20 02:32
I am facing a similar issue right now. I have been with my company for almost 12 years. My company was just sold and as a result I’m facing some issues with my 401k (my loan specifically).
I took out a loan against my 401k for my first home. I’ve been paying without fault. Our new 401k plan was just put in place and we were told to fill out paperwork to rollover our funds. I did so and my funds rolled over, but as a result my 401k loan was defaulted unbeknownst to me! No one told me this would happen. I received a piece of paperwork saying I have 60 days to roll the defaulted funds over to an IRA or perhaps even my employer plan. Basically my company being sold has screwed me. What are my options?
I spoke with our 401k administrator and they are basically suggesting I do what the OP stated. Take out a loan on my new 401k plan and use those funds to dump into an IRA. I’m told that no matter what a 1099R will be sent to me soon and that at the end of the year I should get another document from the starting of the new IRA that will offset that 1099R proving I rolled those funds over.
It seems ridiculous that I have to do this on my own as it was my company who caused all of this and did not send out proper communication regarding what would happen. We even had 401k enrollment seminars and nothing like this was mentioned. I didn’t think to ask about it as i assumed the loan would rollover to my new plan along with my existing funds.
I look forward to any advice you may have.
Thank you.
*Edit: I failed to mention, I technically have the cash to start the IRA if need but I don’t want to pull out of my liquid savings (i.e. nest egg) to do so. I would rather make the monthly payments. I’m just not sure what the best option is. 1) take out loan (if possible) to start IRA, 2) just start IRA with cash, or 3) just take the distribution and pay taxes/penalty. The total is only $6700.
Permalink Submitted by Alan Spross on Wed, 2011-07-20 04:00
Their indication that you can rollover the funds indicate that this is being handled as an offset distribution. The rollover that was completed would therefore have been your former plan balance less the outstanding loan balance.
You do have those options you mentioned:
1) Rollover to IRA within 60 days of the notification the amount you want to shield from taxes and 10% penalty.
2) If you want to preserve your cash, you could apply for a loan from the new plan to replace that cash, but do not let the 60 days expire.
3) You could roll the amount to the new plan if you wanted to since they will apparently accept it. But I think you should opt for the IRA instead.
It sounds like the plan probably fulfilled their legal obligations, at least the options they gave you are typical. Perhaps the timing was bad, but this sort of thing is typical in buyout situations.
If you choose to reapply for a loan, you can take the opportunity to increase or decrease your loan amount. It does not have to be for the same 6700 figure, but the amount you roll over does have to be the remaining balance so when you get the 1099R next January, you can just report a rollover on line 16 of Form 1040 and eliminate any tax or penalty.
Permalink Submitted by Erick Frey on Wed, 2011-07-20 16:35
Yes, it will be interesting to see how things work out for my OP. I saw a check from the company that indicated on the check it was deemed however in the actual plan summary it says distributions tax liability is to be determined by the account holder and tax code and does not explicitly state its deemed.
Either way they have money to make contributions for the year that may help offset some of the taxes even if they still owe penalties and some taxes on the additional distribution amount.
Permalink Submitted by Matthew McDonald on Thu, 2011-07-21 03:28
Thanks Alan-Oniras. Would you have any advice as to which way I should go? I’m wondering if it’s even worth taking a loan out on the new 401k or just forking over the cash. Obviously the money in my savings isn’t really working for me so it seems logical to throw it into the IRA, but I’ve been reading that some advice is to not dump into a retirement plan until you save at least a half-year’s salary in liquid funds, e.g. Savings. I’m at a loss as to what I should do. Should I just see a financial/tax advisor?
Permalink Submitted by Alan Spross on Thu, 2011-07-21 04:00
Probably your job security is the largest variable, and with a new employer you can never be too sure. Were you to lose the job any new loan you took out would also be due within 60 days and you would also need your emergency fund at that time.
If you think the job is secure enough you could complete the IRA rollover. If you don’t complete the rollover you face a tax and penalty, but if you complete it and then need to take funds out of the IRA you will also owe tax and penalty, so that is a wash. Of course, there could be other reasons you would need to tap your emergency fund, but the job is certainly a major issue.
If you have time to investigate a new loan from from the plan, you could determine if that is possible before deciding on the IRA rollover. You just need to be aware of when the 60 days expires as that would eliminate the rollover possibility.