A defaulted 401(k) or TSP loan is treated as taxable income in the year it defaults, and if you’re under 59½ when that happens, the IRS adds a 10% early withdrawal penalty on top. Those are the core 401(k) and TSP loan default tax consequences, but the full picture depends on whether the default happens while you’re still working, whether your plan offers a cure period, and whether you’ve already left the job that sponsored the loan.
When a Missed Payment Turns Into a Taxable Event
Every 401(k) or TSP loan has to meet three requirements under federal tax law: the balance can’t exceed the lesser of $50,000 or half your vested account, the loan must be repaid within five years unless it financed your primary residence, and payments must be made in roughly equal installments at least quarterly.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Once payments stop and the loan slips out of compliance, the IRS treats the outstanding balance as a “deemed distribution.”
The word “deemed” is doing real work. No money actually leaves your account. The plan still carries the loan on its books, and you technically still owe it. But the IRS treats the unpaid balance as if you had received it in cash, which means you owe income tax on money you never touched. Because nothing physically left the plan, a deemed distribution also cannot be rolled over into another retirement account.
The Cure Period That Can Save the Loan
Federal regulations let plan administrators offer a grace period before finalizing a default. The maximum window allowed by law runs through the last day of the calendar quarter after the quarter in which you missed the payment.2Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period The plan document has to authorize the cure period for it to apply.p>
Say you miss a payment due in February. That payment falls in the first quarter, which ends March 31. The cure period runs through the end of the following quarter, so you have until June 30 to catch up on the missed amount and any accrued interest. Pay by that date and the loan is back in good standing as if the lapse never happened. Miss it, and the entire outstanding balance becomes a deemed distribution on June 30.2Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period
Two traps here. Many administrators set a shorter cure period than the federal maximum — 30 or 60 days is common — so check your plan document or call the recordkeeper. And a partial catch-up doesn’t count. If you owe three missed installments and pay only two, the entire balance becomes taxable once the cure period closes.
Payments you make after the cure period expires won’t reverse the deemed distribution. They do, however, create tax basis in your account, which reduces the taxable portion when you eventually take real distributions in retirement.3eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions The default itself is locked in for the year it occurred.
How Much Income Tax You’ll Owe
The full outstanding balance of a defaulted loan is added to your gross income for the tax year of the default. Because the federal brackets are progressive, that extra income stacks on top of whatever you’ve already earned. For 2026, the single-filer brackets are:
- 10%: up to $12,400
- 12%: $12,401 to $50,400
- 22%: $50,401 to $105,700
- 24%: $105,701 to $201,775
- 32%: $201,776 to $256,225
- 35%: $256,226 to $640,600
- 37%: over $640,600
A single filer earning $60,000 who defaults on a $15,000 loan ends up with $75,000 of taxable income. That $15,000 falls entirely within the 22% bracket, adding roughly $3,300 in federal tax. Someone earning $100,000 who defaults on the same $15,000 would see part of it taxed at 22% and part at 24%, because the combined income crosses a bracket boundary.
There’s a secondary problem. Because no cash actually changed hands, nothing was withheld for taxes, and most people don’t learn about the default until the 1099-R arrives in January. By then the tax year is over. Making an estimated tax payment by January 15 of the following year can reduce or eliminate any underpayment penalty.
The 10% Early Withdrawal Penalty
If you’re under 59½ when the deemed distribution occurs, the IRS adds a 10% additional tax on the taxable portion under IRC Section 72(t).5Internal Revenue Service. Substantially Equal Periodic Payments On a $15,000 default, that’s another $1,500. Combined with income tax, a default frequently costs 30% or more of the balance.
A handful of exceptions can wipe out the 10% penalty even when you’re under 59½. The most common one for loan defaults tied to job loss: if you separated from service during or after the year you turned 55, the penalty doesn’t apply to distributions from that employer’s plan. Public safety employees of state and local governments qualify at age 50. Certain federal law enforcement officers, firefighters, customs officers, and air traffic controllers also qualify at 50 under governmental plans and the TSP.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
Other exceptions include total and permanent disability, distributions under a qualified domestic relations order in divorce, and IRS levies against the plan. Note that if the deemed distribution happens while you’re still employed, the separation-from-service exception can’t help, because you haven’t separated.
TSP-Specific Rules
The Thrift Savings Plan follows the same 72(p) framework, with a few administrative wrinkles. The TSP declares a deemed distribution when a participant misses two or more payments and doesn’t cure the delinquency within the applicable cure period, or when the loan isn’t repaid by its maximum term.7eCFR. 5 CFR 1655.15 – Deemed Distributions and Loan Offsets Federal employees in nonpay status for more than a year who haven’t notified TSP of active military duty will also have their loans declared taxable.
One TSP feature surprises people. Even after the TSP taxes your loan as a deemed distribution, the debt itself doesn’t disappear. You can repay the full taxed amount plus accrued interest by check or money order at any point before you separate from federal service.7eCFR. 5 CFR 1655.15 – Deemed Distributions and Loan Offsets That repayment builds tax basis in your account so those dollars aren’t taxed again when you withdraw them in retirement. It does not, however, reverse the tax you already owed for the year of the default.
If you don’t repay a taxed TSP loan, your balance is permanently reduced. The taxed loan still counts as one of the two loans you’re allowed and factors into the maximum loan amount for any future loan.
When a federal employee separates with an outstanding TSP loan, the recordkeeper sends a notice with repayment options. If the participant doesn’t start making payments or repay the balance within the period stated in that notice, the TSP declares a loan offset and zeroes out the debt against the account balance.7eCFR. 5 CFR 1655.15 – Deemed Distributions and Loan Offsets
Leaving Your Job With a Loan Outstanding
A plan loan offset is a different animal from a deemed distribution. When you leave your employer with a loan outstanding and the plan reduces your account to pay off the debt, that’s an offset. Money actually leaves the account, and unlike a deemed distribution, an offset can be rolled over.8Internal Revenue Service. Plan Loan Offsets
The rollover deadline depends on whether the offset qualifies as a “qualified plan loan offset,” or QPLO. Two conditions must be met: the offset must result from either termination of the plan or your separation from employment, and the loan must have been in good standing under IRC 72(p) immediately before the triggering event. The offset must also occur within one year of your separation date.
QPLO Rollover Deadline
If the offset qualifies as a QPLO, you have until the due date of your federal tax return, including extensions, to roll the offset amount into another eligible retirement account.8Internal Revenue Service. Plan Loan Offsets For a 2026 separation, that generally means mid-October 2027 with an extension. This extended window, created by the Tax Cuts and Jobs Act of 2017, gives you time to come up with cash to replace the offset in a new retirement account.
Non-QPLO Rollover Deadline
If the offset doesn’t meet QPLO conditions, the standard 60-day rollover window applies. You have 60 days from the offset date to deposit the equivalent amount in an IRA or another employer plan. Miss that deadline and the full offset becomes taxable income, plus the 10% penalty if you’re under 59½.
Either way, the rollover dollars don’t have to come from the distribution itself. You can deposit personal savings to replace the offset amount. Whatever portion you can’t cover is taxed as ordinary income for that year.
What a Default Does to Future Borrowing
p>A deemed distribution doesn’t remove the loan from your plan’s records. The defaulted balance still counts as outstanding when calculating your maximum borrowing capacity. Under the statutory formula, the most you can borrow is the lesser of $50,000 or half your vested balance, but the $50,000 cap is reduced by the difference between your highest outstanding loan balance in the prior 12 months and your current outstanding balance.9Internal Revenue Service. Deemed Distributions – Participant Loans
Here’s where it stings. If a $30,000 loan defaulted and became a deemed distribution, that $30,000 is still treated as outstanding. Your maximum new loan drops to $20,000, even though you’ve already paid tax on the money. Repaying the defaulted loan is the only way to free up that borrowing room, and even then the 12-month lookback rule still constrains the calculation.10Internal Revenue Service. Retirement Plans FAQs Regarding Loans Some plans go further and bar new loans entirely if you have a deemed distribution on the books. That’s a plan-level decision, not a tax code requirement.
Continuing to Pay After the Default
A deemed distribution doesn’t erase your obligation to repay. The plan still tracks the balance, and interest continues to accrue. The additional interest that builds up after the deemed distribution date does not trigger a second tax event.3eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions
Each post-default payment increases your after-tax basis in the account.3eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions When you eventually take real distributions, the portion attributable to that basis comes out tax-free, which prevents you from being taxed twice on the same dollars. Continuing to repay also clears the loan from the plan’s records and restores future borrowing capacity.
When the Employer’s Error Caused the Default
If a default resulted from an administrative mistake by the employer rather than a choice by the participant, the IRS Employee Plans Compliance Resolution System offers a path to undo the damage. EPCRS lets plan sponsors correct loan failures before they trigger deemed distribution tax reporting.11Internal Revenue Service. Fixing Common Plan Mistakes – Plan Loan Failures and Deemed Distributions
The Self-Correction Program lets the sponsor fix the problem without filing anything with the IRS, but only if the original five-year loan term hasn’t expired. Corrections can involve a lump-sum payment for missed installments plus interest, reamortizing the loan over the remaining original term, or both.12Internal Revenue Service. Revenue Procedure 2021-30 (EPCRS) If the five-year term has already passed, the sponsor can use the Voluntary Correction Program to report the deemed distribution in the current year rather than amending prior returns. In cases involving payroll or processing errors, the employer may bear part of the corrective payment.11Internal Revenue Service. Fixing Common Plan Mistakes – Plan Loan Failures and Deemed Distributions
EPCRS is a tool for plan sponsors, not participants. You can’t file for correction on your own, but if the default happened because your employer mishandled the paperwork, raising the issue with HR or the plan administrator can prompt a correction.
How the Default Shows Up on Your Tax Return
The plan administrator reports both deemed distributions and offsets on Form 1099-R. Box 1 shows the gross amount. For a deemed distribution, Code L appears in Box 7 to signal a paper event under Section 72(p). For a qualified plan loan offset, Code M appears instead.13Internal Revenue Service. Instructions for Forms 1099-R and 5498 Code L distributions cannot be rolled over; Code M distributions can.
The taxable amount from Box 2a flows to the appropriate line on Form 1040.14Internal Revenue Service. Instructions for Forms 1099-R and 5498 If you’re under 59½ and owe the 10% penalty, you’ll generally need Form 5329, unless distribution code 1 appears in Box 7 and the penalty applies to the full amount, in which case you can report it directly on Schedule 2 of Form 1040.15Internal Revenue Service. Instructions for Form 5329
If the 1099-R shows the wrong amount, wrong code, or wrong year, contact the plan administrator immediately. A corrected 1099-R needs to be issued before you can file an accurate return.