If you have taken a 401k loan and are concerned that you may not be able to continue making the payments, you are at risk of 401k loan default. This happens when you stop making your scheduled loan payments to your 401k loan.
There are a few reasons that you may be subject to 401k loan default. The first is that you are no longer an employee of the employer who sponsors the plan, and therefore your payroll deduction 401k loan payments are no longer being processed. Another reason is that your payroll deduction has stopped for some reason.
A 401k record keeper will consider a 401k loan in default if no payments, or incomplete payments, are made for a specified period of time like 90 days. At that point, it is common for a notice to be sent to the participant warning of the pending 401k loan default. How a 401k participant in this situation reacts is up to them.
One option is to continue making loan payments to bring the loan current. In this case, once current, the record keeper will continue processing as normal and the 401k loan will not go into default.
Another option is to pay the loan in full. This may be the best option for someone no longer employed by the plan’s sponsor employer if they have the money available. In this case, the loan will not default and no additional taxes or penalties will apply.
The third option is to allow the default to take place. In this case the participant will be sent a tax form to be used for completing that year’s income tax return. The amount of the 401k loan default will be considered ordinary income in the year of the default and will be subject to taxes at the taxpayer’s normal tax rate. In addition, if the participant is less than 59.5 years old they will be subject to an additional 10% tax on the defaulted balance which will be assessed on the tax return.
The best thing to do is to avoid a 401k loan default, but if that is not possible you should know that one of these outcomes is headed your way. Which one is the right option for you depends on you and your situation.