In 2005, I took a withdrawal from my 401K, which I used as a downpayment on my first and primary place of residence. I was paying it back, when I changed companies in 2006. The old company has reported it to IRS as a taxable income. Now I face additional penalties and taxes. How do I offset my gross salary, being that I used the money for a downpayment.

Thanks a lot.

You cannot offset it.

A distribution for a first time home purchase is NOT permitted from a 401k, only from an IRA.

Sorry about that!

You didn't take a Withdrawal, you took a loan. When you changed companies, since there was an outstanding balance on the loan, that balance was considered a withdrawal. So now, you have to pay taxes and a 10% penalty on that amount. Its too late now to do anything about it but pay.

What you could have done, at the time you switched companies, was to pay off the loan, roll over the account into your new company's plan, then take another loan against the rollover to pay off where you got the money from. I've done this before when switching jobs with an outstanding loan.

ScottGem's point is well taken, but, unfortunately, it is water under the bridge! :-(