What are ramifications of default on 401K loan, can’t afford to pay?

[mary13]

I am still employed, but in a bad financial situation and can no longer make payments 

[Opus 17]

You may not be allowed to default.  Repayments via payroll deduction may be mandatory.  Have you asked HR if you are allowed to stop repayments?  Also, does your employer allow hardship withdrawals?  Not all do.  

[macuser_22]

In addition, it the loan is defaulted while you are still employed then the loan will be paid off from the 401(k) funds which then becomes a taxable distribution taxed at your margional tax rate plus a 10% penalty if you are under age 59 1/2.

[dmertz]

If you are still employed, a deemed distribution that results from defaulting on the loan makes the outstanding loan balance subject to tax and potentially to early-distribution penalty, but it does not pay off the loan.  You are still required to pay off the loan either by later resuming  payments on the loan, which become after-tax basis in the 401(k), or by the 401(k) using a portion of your balance to your credit in the 401(k) (which includes the outstanding loan balance) once you are eligible to receive distributions from the 401(k).

[Carl]

Understand what a 401(k) loan is. Basically, when you take out such a loan you are not really borrowing from your 401(k) per-se. The money in your 401(k) is basically collateral that will be used to pay the loan should you default. Now most situations I'm aware of where one takes out a loan against their 401(k), they are not given an option, but are *required* to pay it back through payroll deduction. For those folks, the only way to default is to lose your job or if your paycheck is garnished through other reasons via the courts.

When you default on a 401(k) loan the most common action is that there is a withdrawal from your 401(k) for the entire outstanding balance of the loan, that is used to pay the loan off. Then, if you are not of retirement age at the time of that withdrawal you will be assessed a 10% early withdrawal penalty and in addition, that withdrawn amount is taxable income that will increase your AGI for the tax year of the withdrawal.

So when you receive the 1099-R at tax filing time (and you will) it will at an absolute minimum show the amount withdrawn in box 1, the taxable amount in box 2 (which will be the same amount in box 1). Do note that the amount shown in box 1 and 2 will be at least 20% *more* than the loan payoff amount. Then in box 4 for federal taxes withheld it will show an absolute minimum of 20% withheld from the total withdrawn. 10% of that is your early withdrawal penalty, and the remaining is federal taxes. Then if your state taxes personal income you'll have an amount withheld for state taxes shown in box 12.

Be aware that for most folks, that 20% withholding with 10% being the penalty, will not be enough to cover the tax liability. It depends on what tax bracket your new *higher* AGI may put you in. So it wouldn't hurt to send the IRS (and the state if applicable) an additional 10% of the total withdrawn to pay off the loan. You can pay it online at www.irs.gov/payments.

[dmertz]

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.