What happens when you default on a 401(k) loan?

Taking a 401(k) loan is a great way to have access to money without going through the conventional ways of borrowing. With a 401(k) loan, you borrow against your retirement savings and pay it back to yourself with interest. Every payment you make goes back into your account. If you default on a 401(k) loan, the unpaid balance becomes a distribution and regular 401(k) withdrawal rules apply.

If you are under 59½ and default on a 401(k) loan, you will owe a 10% penalty and income tax on the loan balance you did not pay back. Your employer might require you to pay the remaining balance in full upon termination if you leave your job before paying off your 401(k) loan. You might also be given a 60-day grace period to pay off the loan and if you fail to pay it off, it will become a distribution.

Here is everything you need to know about defaulting on a 401(k) loan.

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What is a 401(k) loan?

A 401(K) loan is a type of loan where you borrow against your retirement savings. While the amount you can borrow varies from one plan to another, most plans allow you to borrow up to 50% of your account’s vested balance with a maximum of $50,000 in any consecutive 12-month period.

Just like any other loan, the amount you borrowed must be paid back to your account together with interest within 5 years. Before you are allowed to borrow against your 401(k), however, your employer might require a consent letter from your spouse.

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What happens when you default on a 401(k) loan?

When you default on a 401(k) loan, the defaulted money becomes a distribution. And if you default on a 401(k) loan before turning 59½, the balance you owe will become an early withdrawal. As a result, you will pay a 10% tax penalty plus income tax.

401(k) loans vs. 401(k) withdrawals

401(k) loans are easy to qualify and you do not make payments or interest to none other than yourself. Each payment you make goes back into your account. Even if you default on your 401(k) loan, you don’t pay excessive fees except for a 10% penalty you will pay if you are under 59½ and income tax. 401(k) loans are also flexible and when you default, your credit score does not get affected since these loans are not reported to credit reporting agencies.

When you take a 401(k) withdrawal on the other hand, you automatically pay a 10% penalty if you are under 59½ and income tax. The 401(k) withdrawal also affects your account growth as the distribution will affect the compounding interest. Even if you are over 59½, your account won’t grow as much because a big chunk was withdrawn.

For this reason, if you need cash, it is preferable to take out a 401(k) loan than taking an early withdrawal.

What happens when you default on a 401(k) loan while still employed?

Technically, you cannot default on a 401(k) loan while still employed because your loan payments come from your paycheck through payroll deductions. According to Employee Fiduciary, the 401(k) loan is subjected to an enforceable agreement that requires you to repay the loan plus interest at predetermined schedules. Before you qualify for the loan, you must adhere to this agreement. This is why it is unlikely to default on a 401(k) loan while still employed within the same company.

If there was a mistake within your account and your payments were not properly processed, your loan might mistakenly be defaulted. In this case, you can talk to your HR or plan administrator and have the mistake corrected and have the default reverted.

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Do you pay a penalty when you default on a 401(k) loan?

If you default on a 401(k) loan before turning 59½, you pay a 10% penalty on the defaulted 401(k) balance. Similarly to regular 401(k) distributions, you will pay an income tax on that same balance. Your account administrator might also apply a late fee to the account.

How much can I borrow in 401(k) loans?

401(k) loans are great for someone who needs quick cash or cannot easily qualify for conventional loans. Most 401(k) plans allow you to borrow up to 50% of your vested account balance with a maximum of $50,000 in 12 months. When you are applying for a 401(k) loan, qualified accounts are determined based on a “look back” period, according to 4Abenefits. This means that you can borrow a maximum of 50% of all the vested account balances you owned within the last 12 months excluding outstanding balances on these accounts.

For example, if your vested 401(k) balance is $70,000, your plan might allow you to borrow up to $35,000 in 401(k) loans. Your plan will also have the maximum number of outstanding loans you can have at any time.

How long do I have to pay off my 401(k) loan?

After taking out a 401(k) loan, you will have 5 years to pay off the loan. If you can’t pay it off within 5 years, the remaining balance will be defaulted. After defaulting, your lender might give you a grace period to pay it off which is usually 60 days. If you still can’t pay off the loan, the balance will become a distribution and 401(k) distribution rules will apply. You will owe a 10% penalty if you are under 59½ and an income tax on that balance.

If your job is terminated, however, you might be given a much longer period to pay off the balance. According to Experian, if your employment is terminated, you will have up to the tax filing deadline, including extensions to put your defaulted funds or loan offset funds into a Rollover account to avoid tax and early withdrawal penalty. But, if you quit your job, you will have up to 60 days to pay the loan back or deposit your defaulted funds in a qualifying account to avoid tax and penalty.

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What are the 401(k) default rules?

401(k) loan payments are usually collected through payroll deductions. So, as long as you are still employed, the chances of defaulting are low. But, if you leave the job, it will make it harder for the company to collect your loan payments. That is why most companies require a full payment of your remaining 401(k) loan by the time your employment is terminated.

If you quit your job, your company might require that you pay the remaining 401(k) loan balance upon termination. If you cannot pay it right away, the balance becomes a distribution and a 10% penalty and income tax will apply if you are under 59½.

Some employers, however, offer a grace period to repay your 401(k) loan balance after quitting your job. For employer might give you a 60-day grace period to pay the remaining 401(k) balance.

Pros of taking a 401(k) loan

Taking a 401(k) loan comes with many benefits compared to borrowing money from a private lender or taking early withdrawals.

Here are the benefits of 401(k) loans

Lower interest rate. Unlike private loans where you pay high rates, 401(k) loans do not come with excessive rates. Most 401(k) loans charge you 1 to 2% above the prime rate. A prime rate is the lowest interest rate a lender charges borrowers with the best borrowing credentials such as an excellent credit score, clean credit history, and lower DTI ratio. For example, if the prime rate is 3%, your 401(k) loan rate will be around 5% to 6%.

The interest is paid back to you. The entire 401(k) loan payment including interest goes back into your account. That is why a 401(k) loan is like borrowing money from your account and paying it back to yourself with interest.

No foreclosure or collection when you default. Private lenders can take your property in foreclosure if you default on our loan. Defaulting on your 401(k) loan does not come with such harsh financial consequences. When your 401(k) loan is defaulted, the unpaid balance becomes a distribution. Keep in mind that the IRS considers a defaulted 401(k) loan as a distribution. For this reason, you will pay a 10% penalty if you are under 59½ plus income tax.

Easy to qualify. If your plan allows 401(k) loans and you have contributed enough, qualifying for a 401(k) loan might only require a consent form from your spouse and signing a repayment agreement form through payroll deduction.

Defaulting on a 401(k) does not affect your credit score. Unlike conventional loans where your credit score tanks due to a loan default, defaulting on a 401(k) does not affect your credit score as your account activities and 401(k) loans are not reported to major credit bureaus.

Disadvantages of 401(k) loans

While taking out 401(k) loans might sound tempting due to easy access and flexible terms, borrowing against your 401(k) plan also comes with some cons you should know.

Here are the disadvantages of a 401(k) loan

Immediate full payment if you quit. If you leave your employment, you might be required to pay the remaining 401(k) balance upon termination.

10% penalty when you default on a 401(k) before turning 59½. When you default on your 401(k) loan, the IRS treats the unpaid balance as a withdrawal. If you are under 59½, you will pay a 10% penalty and income tax.

Losing growth potential. The biggest drawback of taking a 401(k) loan is probably losing the growth potential in your account. This is because taking money out interrupts the compounding effect on the account, leading to a lower return on investment or slower account growth.

What happens if I don’t repay a 401k loan?

If you don’t pay off a 401k loan, it might cost you more money than you think. The unpaid amount is treated as a distribution by the IRS, and you’ll owe income taxes on that amount. Also, if you’re under 59 ½, you may face an additional 10% early withdrawal penalty. Furthermore, the amount you borrowed will no longer contribute to your account growth, leaving you with less retirement money. Your employer might also require that you pay the outstanding loan balance upon termination which will put a lot of pressure on your finances.