By: Herb Kirchhoff | Reviewed by: Alicia Bodine, Ramsey Solutions Certified Financial Coach | Updated May 29, 2019
It is common to borrow from 401 (k) pension plans. This loan is a powerful tool in meeting critical short-term financial needs. Although the vast majority of 401 (k) borrowers repay their loans, some of these 401 (k) loans end in default. This type of default can lead to various unfavorable tax consequences for the borrower.
When a person borrows money on their 401 (k), they are required to repay that money according to the repayment terms provided. Failure to do so could result in default of payment and various penalties.
Set a default value
A 401 (k) loan, like any other type of loan, is in default when you fail to make scheduled payments. Typically, 401 (k) plans require borrowers to repay their loans by deducting each paycheck. In the event of termination of employment, 401 (k) plans require that any outstanding loan balances be repaid promptly, typically within 60 days of the date of termination. If the borrower does not pay the balance on time, the loan is in default. The main cause of 401 (k) default is loss of a job. A majority of 401 (k) borrowers who have lost their jobs with an unpaid loan balance will eventually default on their loan.
Explore the tax consequences
Normally, money withdrawn from a 401 (k) plan is subject to income tax. That being said, a 401 (k) loan is tax exempt as long as the borrower meets a regular payment schedule. But the balance owed on a past due 401 (k) loan is treated as a distribution from the account and becomes taxable. The borrower will receive a Form 1099 showing the overdue loan balance and will be required to report this amount as income on their tax return.
Understanding the tax penalty
If the borrower is less than 59 1/2, the overdue loan balance is also subject to the 10% federal penalty tax on first 401 (k) distributions. If he is 59 1/2 years or older and defaults due to job loss, he will not owe federal penalty tax in addition to income tax. In states that tax retirement plan distributions, the borrower will also owe state income tax on the overdue loan balance.
Credit effects assessment
A 401 (k) default will normally have no effect on your credit score. Because you borrowed the money from yourself, not your employer or a third party, employers do not report 401 (k) defaults to the credit bureaus. That being said, you will likely incur various tax penalties as a result of the default.