401(k) Loan Repayment Rules: What Happens If You Default?
When times get tough, borrowing from your 401(k) may seem like a smart solution.
After all, it’s your money, right?
But here’s the catch: If you don’t follow the 401(k) loan repayment rules, you could end up facing serious tax bills and penalties, and possibly hurt your retirement future.
Let’s break down what really happens when a 401(k) loan goes unpaid, how deemed distributions work, and why defaulting could hurt more than you think.
How Does a 401(k) Loan Work?
A 401(k) loan lets you borrow money from your own retirement savings…not from a bank.
The amount you can borrow is limited to 50% of your vested account balance or $50,000, whichever is less.
You usually have 5 years to pay it back through regular payroll deductions, although loans used to buy a home can have longer repayment periods.
Your payments go back into your 401(k) account with interest.
So, you’re essentially paying yourself.
But if you don’t follow the 401(k) loan repayment rules, things can get complicated fast.
What Is a Deemed Distribution?
Under IRS 401(k) loan repayment rules, a deemed distribution occurs when you fail to make a required loan payment on time or when your loan doesn’t meet certain IRS requirements for amount, term, or structure.
When you take a 401(k) loan, the IRS requires that:
- Your loan be a legally enforceable agreement with a written repayment schedule.
- Payments must be made at least quarterly and be substantially level (meaning roughly equal payments each time).
- The loan must generally be repaid within 5 years, unless it’s used to buy your main home.
If you miss a payment, your plan may allow a “cure period,” which can’t go beyond the end of the quarter following the missed payment.
If you don’t catch up by then, your plan must treat the unpaid balance as a deemed distribution, and you’ll owe income tax (plus a 10% early withdrawal penalty if you’re under 59½).
A deemed distribution is the IRS’s way of saying, “You broke the repayment rules and now it counts as a withdrawal.”
This is one of the biggest traps people fall into with 401(k) loans.
Even a single missed payment – if not corrected within the allowed time – can turn your loan into a taxable event, damaging both your wallet and your retirement balance.
What Are the Financial Consequences of Defaulting?
Defaulting on a 401(k) loan triggers more than just a headache.
The unpaid balance becomes taxable income for the year it defaults.
If you’re under 59½, the IRS adds a 10% early withdrawal penalty on top of the regular income tax you owe.
And remember, the money you already repaid on the loan was paid with after-tax dollars, which means when you finally withdraw that money in retirement, you’ll get taxed again.
That’s the dreaded double taxation of 401(k) loans.
What Happens to a 401(k) Loan If You Quit or Get Fired?
Leaving your job while you still owe money on a 401(k) loan can trigger one of the biggest risks under the 401(k) loan repayment rules.
Here’s what happens: Once you leave your employer, whether you quit or get laid off, your 401(k) loan usually becomes due in full.
Under the Tax Cuts and Jobs Act (TCJA), you now have until the due date of your federal tax return (typically the following April) to repay the entire remaining balance.
If you can’t repay the loan by that deadline, your plan must treat the unpaid amount as a deemed distribution.
That means the balance is counted as taxable income. And, if you’re under age 59½, you also owe a 10% early withdrawal penalty.
This short repayment window catches many people by surprise.
Before the TCJA, you only had 60 days to pay it back. Now you get a few extra months, but not much more time to come up with thousands of dollars.
Missing the deadline doesn’t just lead to taxes and penalties.
You can also lose out on future growth and possibly employer matches, setting your retirement savings back.
So, if you’re planning to change jobs or think layoffs might be coming, we recommend you check your 401(k) loan repayment rules first and explore ways to pay off the loan before you leave.
Does Defaulting on a 401(k) Loan Affect Your Credit Score?
Here’s one bit of good news: defaulting on a 401(k) loan doesn’t show up on your credit report.
Because the loan is between you and your retirement plan, there’s no bank or credit agency involved.
Your employer reports nothing to credit bureaus, so a missed payment or default won’t directly lower your credit score.
But that doesn’t mean you’re in the clear.
If you break the 401(k) loan repayment rules, the unpaid balance becomes a deemed distribution, and you’ll owe income taxes and possibly a 10% early withdrawal penalty if you’re under 59½.
Even worse, the money you pulled from your 401(k) stops growing.
You lose out on compound growth and possibly employer matches, which may cost you far more than a credit ding ever would.
So while your credit score stays safe, your retirement balance takes the real hit.
401(k) Loans and the Long-Term Cost to Your Retirement Savings
At first, borrowing from your 401(k) might seem harmless…you’re just borrowing from yourself, right?
But over time, the cost of taking and defaulting on a 401(k) loan can be much greater than you think.
When you remove money from your account, that money stops earning compound growth.
Even if you repay the loan, the missed time in the market could possibly shrink your long-term returns.
For example, if you left $10,000 invested for 15 years at a 6% annual return, it could grow to nearly $24,000. But if you borrow that money and default – or even just take years to pay it back – that growth opportunity is gone.
It doesn’t stop there.
Some 401(k) plans pause new contributions while a loan is outstanding.
That means missing employer matching contributions and losing the tax benefits of pre-tax savings.
Combine missed growth, lost matches, and taxes from defaulting, and what seemed like a short-term fix may cost you tens of thousands of dollars over time.
Before touching your 401(k), review your plan’s 401(k) loan repayment rules, and consider other options like an emergency fund, budget adjustments, or financial counseling.
Your future self will thank you.
