What Happens If You Default on a 401(k) Loan?

If you default on a 401(k) loan, the balance is usually treated as a taxable distribution. This may result in income taxes and, if you are under 59½, a 10% early withdrawal penalty. It can also reduce the amount you have available for retirement in the future. A financial advisor can review your situation and help you plan for the tax and retirement impact of a default.

How a 401(k) Loan Works

A 401(k) loan lets you borrow money from your own retirement savings, typically up to the lesser of $50,000 or 50% of your vested account balance. Generally, you must repay these loans with interest within five years, using payroll deductions.

Unlike traditional loans, there’s no credit check, and the interest you pay goes back into your account. But once you leave your job, that convenient payroll deduction ends, and the entire loan becomes due much sooner; namely, the due date of your tax return (including any extensions).

If you leave your job in 2025, you have until April 15, 2026, plus extensions, to repay your 401(k) loan.

What Is Considered a 401(k) Loan Default?

Defaulting on a 401(k) loan means you’ve failed to meet the repayment terms. This can happen in two ways:

You stop making scheduled payments while still employed
You leave your job and fail to repay the remaining balance within the grace period

Once the loan goes unpaid beyond the deadline, the IRS treats the outstanding balance as a “deemed distribution.” The IRS counts this as ordinary income for the year, meaning it’s taxable, and possibly subject to a 10% early withdrawal penalty if you’re under 59½.

If you miss your due date, the loan is considered in default.

What Happens If You Default on a 401(k) Loan?

Preparing before borrowing can help you avoid a 401(k) loan default.

What happens if you default on a 401(k) loan can hit harder than expected. It’s not just a missed payment; it’s a forced, taxable distribution from your retirement plan.

Here’s what you could face:

Income taxes: The IRS adds the entire outstanding loan to your taxable income for the year, which can raise your overall tax bill. Depending on your income, this may also push you into a higher tax bracket.
Early withdrawal penalty: If you are under 59½, the balance is usually subject to a 10% penalty unless you meet one of the limited exceptions, such as disability.
No option to replace the money later: Once the loan defaults, you cannot put the money back into your 401(k). The balance is treated as permanently withdrawn.
Reduced retirement savings: The impact is greater than just the amount of the loan. You also lose years of potential compound growth, which can significantly shrink your future retirement income.
Withholding: Employers may withhold 20% of the balance for federal income taxes. If your actual tax liability is higher, you could still owe more when you file your return.

Even if you feel comfortable with your short-term cash flow, a default can leave a lasting mark by eroding the savings you have worked to build and limiting your income in retirement.

Example Scenario: Defaulting on a $20,000 Loan

Let’s say you borrowed $20,000 from your 401(k) two years ago, and still owe $15,000. You leave your job in 2025 without repaying the balance.

Suppose you don’t roll over the $15,000 or repay it by the tax deadline in April 2026. The plan administrator reports the $15,000 as a deemed distribution, and adds that amount to your income for the year.

If you’re under 59½, you’ll pay:

Income taxes on $15,000 (likely several thousand depending on your tax bracket)
Early withdrawal penalty of $1,500 (10% of $15,000)
Loss of tax-deferred growth on $15,000 for retirement

Defaulting not only costs you in the short term; it also creates a long-term gap in your nest egg.

Are There Any Exceptions or Grace Periods?

If you leave your job with an outstanding 401(k) loan, you generally have until your federal tax filing deadline for that year, including extensions, to repay or replace the balance. For example, if you separate in 2025, you would have until April 15, 2026 (or later with an extension) to make the repayment. This change, introduced by the Tax Cuts and Jobs Act of 2017, provides more time than the previous 60-day window.

However, the rules are strict:

Loan offset rollover: The repayment must be handled as a rollover of the loan offset amount into an IRA or another eligible plan. You cannot simply make a regular contribution.
Missed deadline = distribution: If you do not complete the rollover by the deadline, the IRS treats the unpaid loan as a distribution. The balance is added to your taxable income and may be subject to a 10% early withdrawal penalty if you are under 59½.
No exceptions for hardship: There are no waivers, extensions beyond the filing deadline, or appeals if you cannot make the repayment. Once the deadline passes, the default is permanent.

This rule gives departing employees more breathing room to arrange repayment, but it still requires planning ahead and having access to liquid funds. Without action, the result is an immediate tax bill and a permanent loss from your retirement savings.

Can You “Fix” a Defaulted 401(k) Loan?

Once your loan defaults, the IRS treats it as a taxable distribution, and there’s no way to “undo” it. You can’t return the funds to your account, nor can you roll the balance back into a 401(k) or IRA after the grace period.

However, you can take steps to mitigate the financial impact:

Adjust your withholding or make an estimated tax payment to cover the tax hit
Use part of the deemed distribution for a Roth IRA contribution (if eligible)
Consider working with a financial advisor to reassess your retirement savings strategy

If you anticipate defaulting, it’s better to plan ahead and minimize the tax damage than to be caught off guard.

How to Avoid Default in the First Place

Avoiding a 401(k) loan default comes down to preparation and job stability. If you’re considering a loan, think through what happens if your employment changes.

To reduce risk:

Borrow only what you truly need
Don’t take a 401(k) loan unless you’re confident you’ll stay with your employer during repayment
Build emergency savings outside of your retirement account
Understand the repayment terms and the post-employment grace period
If you’re switching jobs, consider repaying the loan in full or rolling it over before leaving

Taking these precautions can help you avoid the consequences of default and protect your retirement future.

Frequently Asked Questions

Will a Default Hurt My Credit Score?

No. 401(k) loans are not reported to credit bureaus and do not impact your credit score, even in default.

Can I Pay the Loan Off With IRA Funds?

No. You can’t use IRA funds to repay a 401(k) loan. However, you may be able to use other assets and then replenish retirement savings through Roth contributions.

What If I Can’t Afford to Repay Before the Deadline?

If repayment isn’t feasible, prepare for the tax consequences and adjust your budget or savings to offset the loss.

Bottom Line

Defaulting on a 401(k) loan may feel like a minor misstep, but the consequences can be long-lasting. From tax penalties to reduced retirement income, the impact is more severe than most borrowers anticipate. Whether you’re planning to take a loan, already have one or are leaving your job, it’s critical to understand what happens if you default on a 401(k) loan, and how to avoid it.

Retirement Planning Tips

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