Although offering loans in your 401(k) plan is not required, many plans offer this feature. Such a feature allows a plan participant to withdraw pre-tax money from their plan account without incurring taxes on the withdrawal. Generally, 401(k) loans are amortized over a 5 year period and need to be repaid through recurring payroll deductions. If the loan is not repaid, this can cause the loan to go into default.
When a loan defaults, it means that the loan balance becomes taxable to the plan participant. There are a few ways that a loan can go into default. The least common is when a current employee chooses to stop their loan payments. More likely, the participant is terminated or quits and fails to continue making loan payments.
There is a cure period for plan participants to repay their loan. This grace period ends on the last day of the calendar quarter following the quarter in which a loan payment is missed. For example, if Judy terminates employment on March 1st and her next loan payment is due March 15th, her cure period will end June 30th. Judy will have to make up the missing payments or repay the entire loan balance to avoid being taxed on the loan balance.
If the loan defaults, the total taxes could equal as much as 40% of their account if the participant is in a 25% tax bracket for federal taxes, 5% for state taxes, with an additional 10% penalty for early withdrawal if the participant is under the age of 59 ½. For example, if Judy had a loan for the maximum $50,000 and was unexpectedly dismissed from employment and had no means to pay the $50,000 back, she could owe $20,000 in taxes at the end of the year of her default.
If the plan chose to implement the Coronavirus Aid, Relief and Economic Security Act (CARES Act), for participants that qualified, loan payments that were due between March 27, 2020 and December 31, 2020 could be suspended during that time and resume with the first pay in January 2021. The loan would accrue interest during that time of non-payment and could be reamortized over a 6 year period instead of the typical 5 years.
A 401(k) loan can be helpful to participants as they are typically issued at a low interest rate and they will be paying the interest on their loan back to their account. However, plan participants should be aware of the tax implications of taking a loan as the tax consequences can be serious should they default.