What Happens If You Default On A 401K Loan

It can be very alluring to borrow money from your 401(k) to help finance your upcoming major purchase given that many people’s 401(k)s are typically one of their largest retirement savings assets and that many 401(k) providers allow for borrowing. 401(k) loans can be obtained quickly, easily, and without a credit check. Unfortunately, borrowing from a 401(k) has some drawbacks. By being aware of these drawbacks, you can make wise lending decisions and possibly avoid serious tax repercussions. I’ll concentrate on what happens when a 401(k) loan defaults and your options in particular in this article.

401(k) loan basics:

Although the entirety of a 401(k) loan is not the subject of this article, it is still crucial to understand a few fundamentals before moving on to the main subject.

Most plans allow for loans of 50% of your 401(k) balance with a maximum loan of $50,000. That is, if you have a 401(k) valued at $80,000 the maximum you could borrow up to $40,000, while if your 401(k) is valued at and amount greater than $100,000 you could borrow a maximum of $50,000.

You must amortize the loans over a five year period and make regular payments (usually through payroll deductions). The IRS defines timely payments as level amortized payments at least quarterly. Prepaying the loan is completely acceptable and there are no prepayment penalties.

If you cannot pay the loan back (the loan defaults), then the unpaid amount is considered to be a taxable distribution and you could face a 10% penalty if you are under the age of 59½.

How can a 401(k) loan default?

The default rate on 401(k) loans is relatively low due to the fact that the majority of loan payments are typically required to be made with deductions from your paycheck. But the loss of a job is the single biggest reason for loan defaults. Your employer will no longer be able to simply deduct payments from your paycheck after you leave your job (voluntarily or involuntarily), and you must repay the entire amount of the loan as soon as possible (typically within 60 days) to avoid the loan going into default.

Less frequently, loan payments are not deducted from your paycheck and you are then entirely responsible for making timely payments. It goes without saying that placing the burden of timely payments on the loan recipient invites loan defaults. Falling behind on payments can cause a loan to default.

What happens when the loan defaults?

When default is imminent, there are only really two ways to prevent it. You have two options: either let the loan default and deal with the repercussions, or pay back all outstanding principal on the loan (or make up for missed payments if you are not fired from your job).

The consequences can be relatively steep. The IRS plays its cards and collects the overdue taxes and penalties even though this type of “default” won’t result in a negative credit report for you.

Your 401(k) distribution is the unpaid balance that is still outstanding. This distribution will be subject to income tax at your highest marginal rate(s). This “distribution” has a double negative effect. Taxes on what is regarded as a lump sum of income must first be paid. If this happens in a year with high earnings, you might incur a significant tax burden on money that would have otherwise been removed at a lower tax rate. Second, you have taken a significant amount of money out of tax-deferred retirement savings, and you will never be able to put that money back into that preferred tax-deferred status.

Additionally, there could be an early withdrawal penalty tax. As you may already be aware, if you take an early withdrawal from your 401(k) plan before the age of 59 1/2, there is typically a 10% federal tax penalty. However, the age limit for this early withdrawal penalty on defaulted loans is frequently lowered to age 55 because if you left your employer in or after the year in which you turned 55, you may not be subject to the 10% early withdrawal penalty.

Are there any loop holes to avoiding default?

There may be few opportunities to avoid increased taxes and penalties depending on how one defaults.

If you are separated from your job:

There it not much wiggle room in this scenario. However, if you are retiring and in control of when you technically separate from your job it would be a good idea to allow the loan to default in a year when you will not have a lot of taxable income. So, in a best case scenario you would retire at the beginning of the year, allow the loan to default, not earn a lot wages for the remainder of the year, and cause the “distribution” from your 401(k) to be taxed at lower marginal rates.

If you are not separated from your job:

There is a whole lot of opportunity in this case. The IRS has permitted for retirement plan administrators to allow for what is called a cure period. A cure period is essentially a grace period on your loan payment and can last no later than the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

If your employer allows for a cure period (it is their option) there are two ways to get back on track and avoid default:

• During the cure period, you can make up all late payments to keep the loan from defaulting.
• If you refinance the loan, you can essentially re-amortize your payments over a new five-year period while also paying off the original loan and any missed payments.

In conclusion:

Loss of a job can come at any time. Cutbacks, poor performance, a better opportunity for advancement at another company, or simply the need to retire are all reasons why someone might quit their job. This life event may result in a tax burdensome event due to the requirement of prompt repayment of the outstanding loan balance upon separation from employment.

FAQ

What happens when my 401k loan goes into default?

The first consequence of the loan default is taxation. You are taxed on the amount of the outstanding balance. Depending on your age, you might also owe a 10% early withdrawal penalty in addition to regular income taxes. During tax season, these fees and fines may become a significant obligation.

What happens if you don’t pay back a 401k loan?

Any unpaid sums that are not repaid in accordance with the loan’s terms, including interest, become a distribution to you from the plan. If you quit your job, your plan may even demand that you repay the loan in full.

Do you have to pay back a defaulted 401k loan?

The loan must be repaid in the event that you stop working or switch employers. If you are unable to pay back the loan, it is deemed defaulted, and you will be taxed on the remaining balance (along with an early withdrawal penalty if you are under the age of 59 12 at the time of withdrawal). There may be fees involved.

Does defaulting on a 401k loan affect credit score?

Your credit rating won’t be impacted if you default on a 401k loan because the default won’t be reported to the credit reporting companies.