Assuming that you do not default on the loan and cause it to become a deemed distribution, only the interest paid to the 401(k) on the loan is paid with after-tax dollars.  The loan principle is paid back with the before-tax dollars you were originally loaned.

 

The interest paid to the 401(k) on the loan does not become after-tax basis in the 401(k).  You'll pay taxes again on this money when distributed.

 

If you default on the loan and cause it to become a deemed distribution, which is taxable, the deemed distribution does not satisfy the loan.  You'll still be required to pay back the loan but any amounts that you later pay on the loan that are attributable to the deemed-distribution amount become after-tax basis in the 401(k) that will be tax-free when eventually distributed.

Ok... Think of it this way... If you had left the money in the 401K it would have earned taxable income from its investments so when you loaned yourself the money you had to pay interest to the 401K because they invested in you so the interest that you paid is just like the other taxable earnings it made from other investments. They are treated the same so when you do take a distribution from the 401K it's all taxable what you put in and the earnings.

chagrinboy, in your example (where the loan never becomes a deemed distribution) the $10,000 that you are using to pay off the balance of the loan is $10,000 of the pre-tax money you received as the loan, not after-tax money.

 

If an offset distribution is used to pay off the $10,000, it's effectively a taxable distribution from the 401(k) that is used to replace $10,000 of the pre-tax loan that you spent on something else, which is pre-tax money that is turned around to repay the loan.  If you can come up with the $10,000 from some other source to do so you have until the due date of your tax return plus extensions to roll the offset distribution over to an IRA to continue to defer the taxes.

 

In the case where you default on the loan but do not separate from service, the outstanding loan balance becomes a taxable "deemed distribution" but the loan is not satisfied.  Subsequent repayments of the loan principal (but not the interest) then do become after-tax basis in the plan and that after-tax basis becomes basis in nondeductible traditional IRA contributions if the plan balance is later rolled over to a traditional IRA.