Borrowing from 401(k) retirement plans is common. This borrowing is a powerful tool for meeting short-term financial needs that are critical. Although the vast majority of 401(k) borrowers repay their loans, some of these 401(k) loans end in default. This type of default can create a variety of adverse tax consequences for the borrower.
When a individual borrows money from their 401(k), they are required to pay back this money according to scheduled repayment terms. Failure to do so could result in a defaulted loan and a variety of penalties.
Defining a Default
A 401(k) loan, like any other type of loan, goes into default when you fail to make scheduled payments. In general, 401(k) plans require that borrowers repay their loans through a deduction from each paycheck. If employment terminates, 401(k) plans require that any outstanding loan balance must be repaid promptly, typically within 60 days of the termination date. If the borrower fails to pay the balance by the deadline, the loan goes into default. The single biggest cause of 401(k) loan defaults is loss of a job. A majority of 401(k) borrowers who lost their job with a loan balance outstanding will end up defaulting on their loan.
Exploring Tax Consequences
Normally, money taken from a 401(k) plan is subject to income taxes. That being said, a 401(k) loan is exempt from tax so long as the borrower keeps up a regular payment schedule. But the balance owed on a defaulted 401(k) loan is treated as a distribution from the account and becomes taxable. The borrower will receive a Form 1099 showing the defaulted loan balance and must declare that amount as income on his tax return.
Understanding the Penalty Tax
If the borrower is younger than 59 1/2, the defaulted loan balance is also subject to the 10 percent federal penalty tax on early 401(k) distributions. If he is 59 1/2 or over and defaults because of job loss, he won’t owe the federal penalty tax on top of income taxes. In states that tax retirement plan distributions, the borrower will also owe state income tax on the defaulted loan balance.
Evaluating Credit Effects
A 401(k) loan default normally won’t have any effect on your credit score. Since you borrowed the money from yourself, not from your employer or a third party, employers don’t report 401(k) loan defaults to the credit bureaus. That being said, you will likely incur a variety of tax penalties following the default.