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.