Can a Defaulted 401k Loan be Reversed?

Taking a 401(k) loan is a simple way to borrow money from your accumulated retirement savings. If your employer’s retirement plan provides 401(k) loans to participants, you can borrow up to $50,000 or half of your 401(k) balance. 401(k) loans have a quick approval process, and you can get approved in a few days. Unfortunately, many employees who take a 401(k) loan are not prepared for the financial consequences of borrowing, and they often end up defaulting on the loan.

If you recently defaulted on a 401(k) loan, your employer may reverse the default in limited circumstances. For example, if you made loan payments to your 401(k) but the payments were credited to another participant’s accounts, the employer will credit the money to your account and reverse the default. Also, if the loan payments were credited to your account as a 401(k) contribution, the employer will reverse the default and apply the payment to the 401(k) loan account.

When is a 401(k) Considered to be in Default?

When you take a 401(k) loan, you are required to pay back the loan with automatic payroll deductions every month. Therefore, as long as you are working in the employer’s company and getting a paycheck, the chances of defaulting are low. The main cause of default is when you quit or leave the employer and you have an outstanding 401(k) loan. You will be solely responsible for making loan payments on time. If you fall behind in making loan payments, your 401(k) loan will be considered to be in default.

In certain cases, a 401(k) participant may elect to make 401(k) loan payments on their own, instead of having the loan payments deducted from their paycheck. This means that the participant agrees to be fully responsible for timely payments, which opens the door to loan defaults. If the participant is cash strained and unable to make timely loan payments, it can cause the loan to default. Many 401(k) plans allow cure periods, and you can get an extension up to the last day of the quarter after the calendar quarter when the loan payment was due.

Circumstances when a 401(k) loan default can be reversed

Once a 401(k) loan is considered to be in default, it is difficult to have the default reversed unless in limited circumstances. Some of the few circumstances when a 401(k) loan default may be reversed include:

Loan payment credited to the wrong account

When you make a 401(k) loan payment, you pay the money back to your 401(k) account. However, if you sent the loan payment to the wrong account or the employer credited the money to the wrong account, the loan payment will not reflect in your 401(k) loan account. This may cause your 401(k) loan to be in default. Once this error is detected, the loan payment will be recovered and applied to your account.

Loan payment applied as a contribution

Usually, 401(k) loan contributions and 401(k) loan payments are deducted from your paycheck every month and deposited to their respective accounts. However, the employer may wrongly apply both deductions as contributions, causing the 401(k) loan to be in default. When the mistake is identified, the employer should recover the loan payment and redirect the funds to the correct account.

An employer has submitted a Voluntary Compliance Program

A defaulted 401(k) loan can also be reversed when the employer submits a Voluntary Compliance Program (VCP) to the IRS. A VCP is used to correct 401(k) mistakes with how the plan is run or the language used in the plan document. For example, the employer can send a VCP to show that the loan default was due to an administrative error. The employer must send a written submission and pay a fee of $1,500 to $3,500 based on the size of plan assets. Correcting such mistakes through a VCP helps the employer retain its tax-favored status.

What happens when a 401(k) defaults?

When you are unable to make 401(k) loan payments on time, the loan will be considered to be in default. When this happens, the outstanding 401(k) balance will be considered to be a 401(k) withdrawal, and the balance due will be applied to your retirement savings.

Although the employer will not report this default to credit bureaus, you will owe taxes and penalties on the defaulted amount. You will be required to pay income taxes on the distribution at your tax bracket rate. If you have high earnings in the tax year, the 401(k) distribution will push you to a higher tax bracket. If you are below 59 ½, you will be required to pay a 10% penalty for early withdrawal. Also, since the outstanding 401(k) loan balance reduces your 401(k) retirement savings, you will have taken out a sizable amount of money from the tax-deferred retirement account, and you won’t be able to recover the lost future income.