To be clear, if the individual is not eligible to take a regular distribution from the 401(k) due to being still employed by the company and not eligible to receive an in-service distribution, defaulting on the loan results in a deemed distribution that does NOT satisfy the loan. The deemed distribution does not reduce the balance to the employee's credit; the outstanding loan remains an asset of the 401(k) account and the loan is still required to be paid back. If paid back over time, the amounts paid back become after-tax basis in the account. If the employee becomes eligible to receive regular distributions from the 401(k), say, because the employee later separates from service with the company, the loan can be satisfied with an offset distribution. An offset distribution *does* reduce the balance to the employee's credit to satisfy the loan. An offset distribution used to satisfy the loan that defaulted and became a deemed distribution is commonly not reported as a distribution or is reported as nontaxable since the amount has already been taxed as the result of the earlier reported deemed distribution.
What does often happen, although not in this case, is that an employee separates from service and the loan becomes due as a result but the employee has not defaulted on the loan. Under these circumstances, because the (former) employee is eligible to take a distribution from the 401(k), a taxable offset distribution is done to satisfy the loan without the loan ever going into default and without a deemed distribution ever occurring.
