What's a cure period on a 401k loan?

If an employer allows 401(k) loans, employees are more likely to join the 401(k) plan if they know they can tap into their retirement savings before retirement. An employee can borrow to pay for college, medical expenses, or even finance a renovation of their primary residence. However, if you are unable to pay the loan by the end of the cure period, it could fall into default.

A cure period is a period when a missed 401(k) loan payment must be brought back into compliance to avoid triggering a distribution, which has tax implications. A cure period extends to the last day of the calendar quarter following the quarter in which the payment became due. A 401(k) plan must specify the plan's cure period in the plan document.

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

A 401(k) loan is considered to be in default if loan payments are not made on time. Usually, most 401(k) plans require plan loans to be paid through payroll deductions so that there is a lower risk of default. However, an employee can decide to make loan payments via check or request the employer to halt the automatic payroll deductions. Laying the responsibility of timely loan payments on the participant increases the risk of default.

A 401(k) plan must have specific time limits when a 401(k) loan will fall into default. Many plans offer a cure period that extends to the last day of the next quarter following the quarter when payment was due. However, this period could be shorter, or the 401(k) may decide not to allow a cure period.

Using cure period to avoid default

One of the main causes of 401(k) loan default is missed loan payments. If you are unable to make 401(k) loan payments on time, the plan may allow a cure period to pay the missed payment. A cure period can extend until the end of the calendar quarter following the calendar quarter when the payment was due. The plan sponsor may provide a shorter cure period.

For example, if a participant has a monthly loan payment due in March and misses the March 31 deadline, the participant has until June 30 to make the delinquent loan payment before the loan goes into default. The plan administrator may require the delinquent payment to be re-amortized in addition to or as an alternative to paying the missed payment.

What happens when a 401(k) loan defaults?

Generally, when taking a 401(k) loan, you can only borrow up to 50% of your vested balance. This ensures that, in the event of default, the remaining account balance can be used to cover the losses.

If the delinquent payments are not paid within the allowed grace period, the 401(k) loan will fall into default, and it will be considered a deemed distribution. Accordingly, the unpaid loan balance and accrued interests will be reported on Form 1099-R. If you are younger than 59 ½, you could also pay a 10% early withdrawal penalty.

Although the 401(k) loan does not affect your credit, it will stay in the plan’s books until there is a distribution-triggering event. For example, if the participant attains the required retirement age and requests a distribution, the 401(k) balance may be offset by the unpaid portion of the plan.

401(k) Loan Default By Terminated Employees

One of the common reasons for 401(k) default is loss of employment. If you are terminated or leave the company voluntarily before paying off the 401(k) loan, you are required to pay the outstanding loan balance within a short period. For example, if the loan term has three years remaining, you will be required to pay off the remaining loan amount by the tax due date for federal tax returns.

If you cannot afford loan payments, the loan may fall into default. In this case, the IRS assumes you received a distribution equivalent to the amount of the unpaid loan. The distribution is known as a plan loan offset, and it will be taxed as an income unless an equivalent amount is contributed if you decide to rollover to an IRA or other qualified retirement plan. The rollover should be completed within 60 days after leaving the employer, but if it qualifies for a waiver, you may be able to rollover the loan offset before the tax filing date for the year in which the distribution occurred.