Can I Voluntarily Default on my 401k Loan?

Borrowing from your 401(k) retirement savings is a simple way to raise money for a big purchase or short-term emergencies. 401(k) loans are quick and easy, and participants are not subjected to credit checks to ascertain their creditworthiness. However, if an employee defaults on the 401(k) loan, there are steep tax consequences.

If you are struggling to keep up with the 401(k) loan repayments, you can voluntarily default on the repayments. However, this mainly happens when you quit or are terminated from your job since your former employer will no longer make payroll deductions to repay the 401(k) loan. Instead, you will be fully responsible for 401(k) payments to clear the unpaid 401(k) loan. If you are unable to pay the outstanding balance within the required period, you can opt to default on the loan, and the outstanding 401(k) loan will be converted into a 401(k) withdrawal.

How Can a 401(k) Loan Default?

The main cause of 401(k) loan default is loss of employment, either voluntary or involuntary. When you are still working with your employer, the 401(k) loan installments are paid through automatic payroll deductions, which makes it difficult to default. However, when you quit or move to another job, your employer stops making payroll deductions to repay the 401(k) loan installments.

In the absence of automatic payroll deductions, the employee is fully responsible for making timely loan payments. This change increases the risk of loan default if they fall back on making timely payments. Also, giving the employee full responsibility to make loan repayment opens doors to loan default, especially if the employee’s finances are strained.

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

If you quit your job or are terminated from employment and you have an outstanding 401(k) loan, the balance is due within 60 days from the last day at work. You must come up with sufficient cash to pay off the loan within the allowed period, otherwise, the balance will be treated as a withdrawal and you will owe taxes on the unpaid 401(k) loan balance.

In some cases, the IRS allows 401(k) administrators to extend a cure period to employees who are at risk of default. The cure period may extend up the last day of a calendar quarter after the calendar quarter when the loan installment was due.

What Happens When You Default?

401(k) providers allow participants to borrow up to 50% of their 401(k) retirement savings up to a maximum of $50,000. This means that, in the event of default, the 401(k) plan is protected and the employer can use the retirement savings to cover the outstanding loan balance. If you have a 401(k) loan that is at risk of becoming delinquent, you have two options to consider i.e. pay off the outstanding balance or let it default.

If you don’t have the money to pay off the outstanding 401(k) loan balance, you can let the 401(k) loan default and deal with the tax consequences. The loan default is treated as a 401(k) withdrawal or distribution, which creates a tax liability. While the delinquent payment will not be reported to credit bureaus, you will owe taxes and penalties on the distribution. A bigger distribution will increase your annual earnings and push you to a higher tax bracket.

Also, if you are below 59 ½ at the time of default, you will be subject to a 10% federal tax penalty. However, if you quit your job at or after 55, you may be exempted from the penalty tax, but you will still owe income taxes at your tax bracket.

Consequences of Defaulting on a 401(k) Loan

While a 401(k) loan can be a quick source of funds for short-term emergencies, it comes with certain consequences if a borrower defaults on the loan. One of these consequences is the tax you will owe on the outstanding 401(k) loan at the time of default. For example, if you took a $30,000 401(k) loan, and paid down $10,000 before defaulting, it means that you will pay income tax on the remaining $20,000. Assuming that your annual income pushes you to the 20% tax bracket, it means you will pay 30% tax (including the penalty tax if you are below 59 ½) on the distribution. 

Another consequence of defaulting on a 401(k) loan is the impact it will have on your retirement nest egg. Once you default on your 401(k) loan, the plan administrator will consider the loan as a withdrawal, which will reduce your 401(k) vested balance. For example, if you were unable to pay $20,000 in outstanding loan balance, this amount will be offset against your account balance. This will have a permanent impact on your 401(k) retirement savings unless you can afford to make bigger contributions without exceeding the IRS contribution limits.

Will a 401(k) Loan Default Affect Your Credit Score?

If you default on a 401(k) loan, your employer will not report the delinquent account to credit bureaus. Hence, defaulting on a 401(k) will not affect your credit score. Rather, once you default on your 401(k) repayment, the plan administrator will send you Form 1099 and a copy of this form will be sent to the IRS. This form reports the amount you owe the IRS in taxes, and you will have until April 15 of the following year to pay annual income tax returns.

Can You Avoid 401(k) Loan Default?

There are certain situations when a 401(k) loan borrower can avoid loan default or minimize the tax consequences arising from 401(k) loan default.

If you are still working for the employer who provided the loan, you can request a cure or grace period. This period allows you more time to pay the delinquent loan payments after the period when the loan payment was due. A cure period increases the repayment period up to the last day of the calendar quarter after the calendar quarter when the installment was due. If your employer allows a cure period, you can use this period to pay all the missed 401(k) loan payments or clear the outstanding loan balance to avoid the loan going into default.

On the other hand, after you are separated from your employer, you are not eligible for a cure or grace period. If you still have an unpaid 401(k) loan after 60 days from the date you left your job, the loan will be considered to be in default and you will owe taxes on the unpaid balance. In this case, you can allow the loan to default in a year when you don't have a lot of taxable earnings, so that your total annual income falls in a lower tax bracket.