What Happens If a 401k Loan Is Not Paid Back?

Borrowing from a 401(k) can seem like an easy way to access cash without going through a traditional lender. However, failing to repay the loan on time can lead to financial consequences, including taxes, penalties, and setbacks for retirement savings. Many borrowers underestimate these risks, assuming they can simply pay back the loan later or roll it into another plan.

Understanding what happens when a 401(k) loan goes unpaid is essential to avoiding costly mistakes.

When the Loan Is Deemed in Default

A 401(k) loan is in default when the borrower misses scheduled payments. Most plans require repayment through payroll deductions, so missed payments can quickly lead to delinquency. The IRS provides a grace period—typically until the end of the calendar quarter following the missed payment—to catch up. If the borrower does not bring the loan current within this timeframe, the plan administrator classifies the outstanding balance as a “deemed distribution.”

At this point, the loan is treated as a withdrawal from the retirement account. The unpaid balance is reported on IRS Form 1099-R as taxable income for the year of default. Unlike traditional loans, there is no option to renegotiate terms or restructure the debt. The IRS does not allow repayment after default to reverse the tax consequences.

Additional Taxes and Penalties

Once a 401(k) loan is classified as a deemed distribution, the outstanding balance is subject to federal income tax. The IRS treats the unpaid amount as ordinary income, taxed at the borrower’s marginal rate, which can range from 10% to 37% depending on total earnings for the year. This reclassification can push individuals into a higher tax bracket, increasing their overall tax liability.

Borrowers under age 59½ also face a 10% early withdrawal penalty unless they qualify for an exemption, such as total and permanent disability or significant medical expenses. Without an exemption, a borrower in the 22% tax bracket would owe 32% of the loan balance in combined taxes and penalties.

State taxes can add to the financial burden. California, for example, imposes a 2.5% early withdrawal penalty in addition to federal taxes. A borrower there could face a total tax burden of 34.5% or more on the unpaid loan amount.

Employer Policies for Unpaid Balances

Employers determine how they handle unpaid 401(k) loans, and their policies can significantly impact a borrower’s financial situation. While federal regulations dictate when a loan is considered in default, the employer’s plan document outlines specific procedures for handling outstanding balances. Some employers provide a short grace period before reporting the loan as taxable income, while others process the default immediately.

Many companies require full repayment of the loan if an employee leaves the organization. Under the Tax Cuts and Jobs Act of 2017, borrowers who separate from their employer have until the due date of their tax return, including extensions, to repay the loan or roll over the balance into another qualified retirement plan. If repayment is not made within this timeframe, the loan is treated as a distribution, triggering tax consequences. Employers are not required to notify departing employees of this deadline, making it important for borrowers to stay informed.

Some employers impose restrictions on future plan participation for employees who default on a loan. This can include barring them from taking new loans for a set period or prohibiting further borrowing altogether. Defaulting can also affect an employee’s ability to make elective deferrals if plan rules require outstanding loans to be repaid before new contributions can be made.

Plan Document Provisions

Each 401(k) plan is governed by a formal document that outlines the terms for loans, including repayment schedules, interest rates, and borrowing limits. While the IRS sets overarching limits—such as the $50,000 or 50% of vested balance cap—individual plans may impose stricter borrowing limits. Some employers set lower thresholds to reduce administrative burden or mitigate risk to the retirement plan.

Loan repayment terms are also dictated by these documents, with most plans requiring full repayment within five years unless the loan is used to purchase a primary residence. Interest rates, which must be comparable to commercial lending rates, remain fixed for the duration of the loan. Unlike traditional loans, interest paid on a 401(k) loan is deposited back into the borrower’s account rather than paid to an external lender. While this may seem beneficial, it often results in a net loss compared to potential market returns if the funds had remained invested.

Withholdings and Offset

When a 401(k) loan is not repaid, the plan administrator may use a process known as loan offset to recover the unpaid balance. Unlike a deemed distribution, which occurs when a borrower fails to make scheduled payments, an offset happens when an individual separates from their employer and does not repay the remaining loan amount within the allowed timeframe. The outstanding balance is deducted directly from the participant’s retirement account and treated as a distribution for tax purposes.

The IRS allows individuals to mitigate the tax consequences of an offset by rolling over an equivalent amount into another eligible retirement plan or IRA. Under the Tax Cuts and Jobs Act, borrowers have until the due date of their tax return, including extensions, to complete this rollover. If they fail to do so, the offset amount is taxed as ordinary income, and if they are under 59½, the 10% early withdrawal penalty applies. Unlike a deemed distribution, which cannot be reversed, an offset provides a window of opportunity to preserve retirement savings if the borrower can secure alternative funds to complete the rollover.

Effect on Retirement Accumulation

Defaulting on a 401(k) loan not only results in immediate financial consequences but also affects long-term retirement savings. The unpaid balance permanently reduces the account’s value, eliminating potential investment growth. Since 401(k) contributions are typically invested in diversified portfolios, missing out on years of compounded returns can significantly impact the total balance at retirement. For example, a $20,000 loan that defaults at age 40 could result in a loss of over $80,000 in potential growth by age 65, assuming a 7% annual return.

Some plans restrict participants from making new contributions after defaulting on a loan. If an individual is barred from contributing for six months or longer, they may miss out on employer matching contributions, further diminishing their retirement savings. Even if contributions resume, the lost time in the market can be difficult to recover, particularly for those nearing retirement. This underscores the importance of carefully evaluating the long-term impact before borrowing from a 401(k), as the short-term benefits of accessing cash can be outweighed by lasting financial setbacks.