Defaulting on a 401k loan can have serious financial consequences. When you borrow from your 401k, you are taking money out of your retirement savings. Failure to repay that loan triggers tax penalties and can greatly impact your retirement security. This article will explain what happens when you default on a 401k loan and how to avoid negative outcomes.
What Triggers a Default?
A 401k loan default occurs when you fail to make payments as outlined in the loan agreement Typically, 401k loans must be repaid within 5 years through quarterly payments. Missing scheduled loan payments is the primary cause of 401k loan defaults.
Other common triggers include:
-
Job loss or leaving your employer – Loans must usually be repaid in full within 60 days of ending employment, Failure to do so results in default,
-
Financial hardship – Struggles meeting living expenses can make it difficult to also repay 401k loans.
-
Neglect – Simply forgetting or neglecting to make timely payments leads to default.
Essentially any situation leading you to miss loan payments will trigger default if not promptly corrected.
Tax Consequences of Default
The most damaging impact of defaulting on 401k loans is the tax penalty it incurs. When you default, the outstanding loan balance is treated as a distribution from your 401k account. This taxable distribution is reported to the IRS and you must pay income tax on the amount.
For example, defaulting on a $10,000 401k loan would increase your taxable income for the year by $10,000. If you are in the 22% income tax bracket, you would owe $2,200 in extra federal income taxes.
State income taxes often apply as well, further increasing the tax bite of a 401k loan default.
Early Withdrawal Penalties
Defaulting can also lead to early withdrawal penalties if you are under age 59 1⁄2. The IRS imposes a 10% penalty on 401k distributions before this age. With a $10,000 default, you would incur a $1,000 early withdrawal fee.
Some states also penalize early 401k withdrawals. California adds 2.5%, meaning a $10,000 default would create a $250 state penalty.
These penalties apply even though a default is involuntary and not an intentional withdrawal from your 401k.
Loss of Retirement Savings
When you default on a 401k loan, the outstanding balance is taken from your 401k account assets. For example, defaulting on a $10,000 loan essentially withdraws $10,000 from your 401k balance. This permanently reduces your retirement savings.
Rebuilding that savings requires contributing more than you otherwise would have. With IRS limits on annual 401k contributions, restoring defaulted amounts can be challenging.
No Impact on Credit Scores
One positive is that 401k loan defaults are not reported to credit bureaus like defaults on other loans. Defaulting does not directly hurt your credit score.
However, having less retirement savings can impact your ability to qualify for future loans, including mortgages. And the tax consequences of defaulting indirectly affect your finances for years.
Options to Avoid Default
While 401k loan defaults create massive headaches, you have options to avoid negative outcomes:
-
Reinstate payments – If you miss payments but resume repaying the loan promptly, you may avoid default. Some plans allow a 60-90 day grace period.
-
Pay off balance – Paying off the outstanding loan balance prevents a default. Options include using non-retirement savings or taking a loan from another source.
-
Rollover balance – When leaving your employer you may be able to roll the loan into an IRA and continue payments.
-
File bankruptcy – Defaulted 401k loans can potentially be discharged through bankruptcy.
-
Request hardship waiver – You may qualify to have the loan terms modified if facing financial hardship.
-
Time the default strategically – If default is inevitable, do so in a year your income is lower to minimize tax impact.
While inconvenient and disruptive, proactively managing 401k loans can help avoid default and major damage to your finances. Seek help from your 401k administrator or a financial advisor if struggling to repay.
Key Takeaways
-
Defaulting on a 401k loan occurs when you fail to make payments as scheduled. This often results from job loss, financial hardship, or neglecting payments.
-
Default triggers income taxes and possibly penalties on the outstanding loan balance, which is treated as a distribution from your 401k.
-
These tax consequences reduce your take-home pay and can negatively impact your finances for years.
-
Default also permanently removes money from your 401k account, reducing your retirement savings.
-
To avoid default, resume payments promptly, repay the balance by a deadline, roll over the loan, or request a waiver if facing hardship.
-
While default hurts your finances, it does not directly damage your credit score like other types of loan defaults.
Avoiding default requires proactive management of 401k loans. However, you have options to mitigate or avoid negative outcomes if struggling to make payments. With proper planning, you can prevent 401k loan default from seriously derailing your finances.
Under what circumstances can a loan be taken from a qualified plan?
A qualified plan may, but is not required to provide for loans. If a plan provides for loans, the plan may limit the amount that can be taken as a loan. The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
For example, if a participant has an account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000.
A participant may have more than one outstanding loan from the plan at a time. However, any new loan, when added to the outstanding balance of all of the participant’s loans from the plan, cannot be more than the plan maximum amount. In determining the plan maximum amount in that case, the $50,000 is reduced by the difference between the highest outstanding balance of all of the participant’s loans during the 12-month period ending on the day before the new loan and the outstanding balance of the participant’s loans from the plan on the date of the new loan.
For example, assume Participant A has a vested account balance of $100,000 and took a plan loan of $40,000 on January 1, 2005, to be paid in 20 quarterly installments of $2,491. On January 1, 2006, when the outstanding balance is $33,322, Participant A wants to take another plan loan. The difference between the highest outstanding loan balance for the preceding year ($40,000) and the outstanding balance on the day of the loan ($33,322) is $6,678. Since the new loan plus the outstanding loan cannot be more than $43,322 ($50,000 – $6,678), the maximum amount that the new loan can be is $10,000 ($43,322 – $33,322). See Computation of maximum loan amount from retirement plans (podcast).
A plan may require the spouse of a married participant to consent to a plan loan. (IRC Section 417(a)(4))
A plan that provides for loans must specify the procedures for applying for a loan and the repayment terms for the loan. Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest and that are paid at least quarterly. Loan repayments are not plan contributions. (Reg. Section 1.72(p)-1, Q&A-3)
A loan that is taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a period of more than 5 years. (IRC Section 72(p)(2)(B)(ii); Reg. § 1.72(p)-1, Q&A-5,-6, -7, and -8)
A plan may suspend loan repayments for employees performing military service. (Reg. Section 1.72(p)-1, Q&A-9(b))
A plan also may suspend loan repayments during a leave of absence of up to one year. However, upon return, the participant must make up the missed payments either by increasing the amount of each monthly payment or by paying a lump sum at the end, so that the term of the loan does not exceed the original 5-year term. (Reg. Section 1.72(p)-1, Q&A-9(a))
Loans are not dependent upon hardship. Some plans may provide for hardship withdrawals, however. See FAQs on hardship distributions.
As long as a plan provides for loans, the purpose of the loan or the participant’s ability to borrow the same amount elsewhere is irrelevant in determining whether the loan is permitted, unlike hardship withdrawals, which require a demonstration of need. See FAQs on hardship distributions.
The participant’s relationship to the plan (e.g., being an owner of the plan sponsor) does not affect the participant’s ability to take a loan, as long as all participants are equally able to take loans under the plan’s loan provisions.
Loans are not taxable distributions unless they fail to satisfy the plan loan rules of the regulations with respect to amount, duration and repayment terms, as described above. In addition, a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such. (IRC Section 72(p); Reg. Section 1.72(p)-1, Q&A-1)
If your 401(k) plan or 403(b) plan has made loans that haven’t complied with plan terms about loans, find out how you can correct this mistake.
What is a plan offset amount and can it be rolled over?
A plan may provide that if a loan is not repaid, your account balance is reduced, or offset, by the unpaid portion of the loan. The unpaid balance of the loan that reduces your account balance is the plan loan offset amount. Unlike a deemed distribution discussed in (5), above, a plan loan offset amount is treated as an actual distribution for rollover purposes and may be eligible for rollover. If eligible, the offset amount can be rolled over to an eligible retirement plan. Effective January 1, 2018, if the plan loan offset is due to plan termination or severance from employment, instead of the usual 60-day rollover period, you have until the due date, including extensions, for filing the Federal income tax return for the taxable year in which the offset occurs.
Can I voluntarily default on my 401k loan?
FAQ
What happens when a 401k loan goes into default?
A 401k loan is a loan from yourself to yourself. If you default on it, then whatever is left of the loan is recharacterized as an early withdrawal subject to penalties and relevant taxes.
What happens if I can’t pay back my 401k loan?
What is the 5 year rule for 401k loans?
Generally, the employee must repay a plan loan within five years and must make payments at least quarterly.
Can a 401k loan be forgiven?