Can I stop paying my 401k loan?

For most workers, contributing to a 401(k) plan is a useful way to accumulate retirement savings and unlock your old 401(k)s. However, these workers may find themselves in a financial crisis, with no other sources of funds other than their 401(k) plan. If you find yourself in such a position, you could consider taking a 401(k) loan at a reduced interest rate. The employer then deducts the loan payments automatically through payroll deductions.

You can stop paying your 401(k) loan when you leave your job or opt-out of automatic payroll deductions. Once you are separated from your job, your employer will no longer debit your paycheck to pay off the outstanding balance since you are no longer working for the company. After leaving your job, you will be solely responsible for paying the unpaid loan amount before the tax due date. Also, if you opt-out of automatic payroll deductions, you will be solely responsible for making loan repayments, and this opens doors to loan defaults.

When Can You Stop Paying Your 401(k) Loan?                                

Job loss

One of the reasons for 401(k) loan default is job loss. When you are terminated or voluntarily leave employment, your employer will no longer make payroll deductions to repay the loan. Instead, you will be required to make loan payments to the 401(k) account. Since you are accustomed to automated loan payments, you are likely to fall back on loan payments. Also, if you are cash strapped and unable to make timely loan payments, you can voluntarily stop making loan payments so that the unpaid loan can be considered a distribution.

You opt out of payroll deductions

Usually, when you borrow from a 401(k) plan, you are required to make loan payments through automatic payroll deductions. However, you can opt-out of automatic payroll deductions, and pay the loan installments via check. If you miss out on several payments, it can cause your 401(k) loan to default.

What Happens When a 401(k) Loan Defaults?

A 401(k) loan is considered to be in default when loan payments are not made on time. Most 401(k) plans allow a cure period after the last day when a loan was due, which can extend until the last day of the next quarter. If you don't pay the outstanding loan within the cure period, the unpaid loan will be treated as a withdrawal, and you will owe taxes. Since 401(k) plans allow participants to borrow up to 50% of their account balance, it means that the account has enough money to cover the loss. Therefore, the unpaid loan will be considered to be a deemed distribution, which is subject to income taxes, and a penalty tax if you are below 59 ½.

Consequences of Not Paying a 401(k) Loan

If you stop paying your 401(k) loan, you could face the following consequences:

You will owe taxes

When your 401(k) loan is considered to be in default, the plan sponsor will send you Form 1099 showing the distribution amount and the amount of taxes you owe. You will have to pay income taxes on the lump-sum distribution at your tax bracket rate. If the "distribution" occurs in a year of high earnings, you will be pushed to a higher tax rate, and you will owe more taxes.

Early withdrawal penalty

If you are below 59 ½, or you left your job when you were younger than 55, the distribution will be subject to a 10% early withdrawal penalty. However, if you left your job at 55, you will only pay income taxes on the distribution.

Lost appreciation opportunities

Once you default on a 401(k) loan, the unpaid amount is considered to be a deemed distribution, which is deducted from your account balance. This takes a sizable chunk of money out of the 401(k) account, and you will never be able to get the money back to the retirement account. This denies the funds an opportunity to grow tax-deferred, and this money can't be replaced once it is withdrawn. After taking a 401(k) loan, the 401(k) plan may limit how much you can contribute to the plan, making it impossible to return the money back to its tax-preferred status.

Will 401(k) Loan Default Hurt My Credit?

When you take a loan, the lender requests a copy of your credit report as part of the credit check. If you have a history of defaults and foreclosures, these records will appear on the credit report. However, 401(k) loans are different from traditional loans, and they are treated differently. When you take a 401(k) loan, you are borrowing from your retirement savings, hence there is no lender to conduct a credit check. Therefore, if you default on the loan, you will not be reported to credit bureaus, and this information will not show up on your credit report.