401k Loan Default Consequences and Penalties

Being the “victim” of a 401k loan default is not fun. Let’s talk about what that really means to you so there are no surprises come tax time when the IRS is knocking on your door and asking for their money.

Unfortunately, jobs are not always secure and if you have a loan outstanding, the risk of a 401k loan default is great. You might be asked to leave, or you might find a better offer someplace else and you end up leaving before you ever thought you would. This happens all the time. It’s not the end of the world. Life is unpredictable, so it’s very difficult to plan for. But you should at least prepare for it.

If you leave service from your employer you should make every effort to repay any outstanding loan balance you have. As a matter of fact, when you take out a 401k loan, you should always try to build a separate “pile” of money so you can pay the loan off in full if there is ever a need to.

Avoiding a 401k loan default should be top priority.

Generally, you are given only 90 days from when you leave service to repay your loan in full (you probably won’t be able to make partial payments, but you should check just in case). You will be required to repay the loan earlier than 90 days if you decide to distribute the account and roll the money over to another retirement vehicle before your 90 days are up.

If you don’t repay your loan after separation of service, the outstanding balance will be in default and treated as a taxable distribution to you in the year in which it occurs (this is because you’ve never paid taxes on the money before). You will receive a 1099-R form to include with your income tax returns, and you may be required to pay Uncle Same a 10% early withdrawal penalty as well.

This is a horrible deal. Not only have you now lost the opportunity for that money to work for you in the form of compounding interest, you’ve also paid taxes and penalties on it now, too. Not to mention that you have just short-changed yourself in retirement funds.

Be careful!