A participant takes out a loan at age 53 with a 5 year repayment option. The participant terminates employment at age 56. How should the loan be handled if the participant takes a lump sum distribution? Since the participant separated from service after age 55, would she qualify for the 10% penalty exemption?

I believe participant would qualify for the exemption from the 10% penalty tax, but I haven't looked it up to make sure, so I wouldn't trust my opinion just yet!

I agree Belgarath,

A loan offset is treated as a regular distribution for this purpose.

This is a bit old, but thought I'd add my thoughts. Yes, she qualifies for the exemption from the penalty, but you must withhold 20% on the entire lump sum balance, including the outstanding loan, when you pay her out.