When 401(k) Loans are Considered to be in Default

When 401(k) Loans are Considered to be in Default

By Wiss (497 words)
Posted in Employee Benefit Plan Audits on November 08, 2016

There are (11) comments.

By Laura Zindel

Taking out a 401(k) loan can seem like a relatively simple way to borrow money. It is a very common practice, but many employees who borrow from their plans aren’t prepared for the financial consequences of doing so if a loan ends up in default.

The most common reason for defaulting on a 401(k) loan is the loss of a job. If the employee loses his or her job, the plan document rule requires that any outstanding loan balance must be repaid within a certain timeframe, based on when the default occurred. Most plans require employees to repay their loans through payroll deductions, and employees become so accustomed to this automated process that they don’t even realize their loan is no longer being repaid after termination — until it’s too late. 

Participants who are still employed can also default on loans. If they elect to forgo the automatic payroll deductions and pay via a check, or ask their employer to halt the automatic payroll deductions, they are still at risk for a loan default if payments to their loans are not made timely. 

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

As with any loan, 401(k) loans default when payments aren’t made on time. Each plan can specify its time limits, but many plans offer cure periods, or grace periods, that extend until the last day of a calendar quarter following the calendar quarter when a missed payment was due. For example, if you miss a loan payment that was due July 1, you would have until Dec. 31 to make a payment before your loan goes into default.

What happens when a 401(k) loan defaults?

Plans allow loans to be the lesser of 50 percent of a participant’s 401(k) balance, or $50,000, so that, if they default, the remaining account balance has sufficient assets to cover the loss. Once a loan defaults, this action is treated as a 401(k) withdrawal, which is subject to taxation. Accordingly, the plan administrator will issue a 1099 to the participant showing the distribution amount and what taxes are owed. In addition, if you’re younger than 55, you’re also subject to a 10 percent early withdrawal penalty.

Although 401(k) loan defaults don’t impact your credit score or carry long-term consequences, the short-term costs can be daunting.

Employees don’t often consider this worst-case scenario when taking out a 401(k) loan. Instead, they assume they have five years to pay it back through payroll deductions. So before moving ahead with a loan, first consider what your long-term plans are for your career and what would happen if you stopped receiving paychecks and ended up in default.

Laura Zindel is an Audit Manager with over 6 years of public accounting experience. She has provided audit, accounting, tax and business advisory services to privately-held businesses in industries such as manufacturing, wholesaling/distributing, and professional service firms. Laura is involved with the Employee Benefit Plan Group at the firm and audits several Defined Contribution and Defined Benefit Plans.

Comments (11)

Tom posted on: September 27, 2017

I took out a loan from my 401K plan back in 2013. Without going into all the details my payroll deducted payments were not made timely. I was told by my company's plan administrator the mistake was the payments were paid every pay period instead of every 15 days causing me to slowly go into default, AXA Equitable was the "sponsor" with our office manager in charge of the day to day responsibilities. I was issued a 1099 and penalized for this default. My question's are....

1. Was my plan mismanaged by either AXA or my plan administrator? And if so...
2. Was there a breach of fiduciary responsibility?
3. Do I have any recourse for any potential mismanagement not caused by me?

I felt confident my payments were being made on time, I saw them on my pay stub.

John posted on: February 23, 2018

I had taken out a 401k loan for a down payment on my current property. The loan almost went into default but I was able to bring the loan current and reinstate the loan. I went onto the fidelity investment website to find out that they reported the loan as a default. When I called the Fidelity Investment customer service center they initiated an investigation. After 4 weeks fidelity investments would not reinstate the loan. The default was an error from the customer service end but the default would stand although it was admitted that they were in the wrong.
Iam going to initiate a formal complaint to Fidelity Investments. Wondering if you have any advice on this. I plan on going up the food chain. Someone will eventually listen. I also thought about complaining to the IRS about this.
Help!

Priscilla kinard posted on: February 26, 2018

I was in a car accident that caused me to be out of work for a year and I had a 401k loan at the time for the fist six months the money came out of my paycheck as usually and then I went in to long term which was another six months at that time I was being payed by a third party so the loan payment was no longer coming out of my paycheck which cause me to default on my loan. My 401k provider said they had sent me a correspondent but I didn't get it and the next letter they sent was telling me that I was in default. What can I do

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Subie posted on: March 25, 2018

I do not know if my recent experience will help but this is what I did. I took a loan and then left the company where I worked. I called the "sponsor" company (big name company - dont want to mention) and asked if I can make monthly payments and the agent says yes. After making a few payments the "sponsor" (big name co that I do not want to mention here) sent me a letter saying my loan is in default because 60 days have passed since I left the company. I filed a complaint mentioning that the agent misled me but was denied by customer service. I contacted the legal department of the "Sponsor" company and asked for the audio tape of my conversation (luckily I had the date and time of my original conversation) so that I can prove I was misled. Things went right from there and the sponsor admitted and paid me around $25,000. What you need to do is establish that either the office manager or the customer service rep made a mistake. That all I proved.

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