If you stop paying back a 401k loan, the IRS treats the unpaid balance as a distribution from your retirement account. You owe ordinary federal income tax on the full outstanding amount, plus a 10 percent early withdrawal penalty if you’re under 59½, plus state income tax in most states. Combined, that can take 30 to 40 percent of the balance. And unlike most retirement distributions, a defaulted loan can quietly set you up to be taxed on the same money twice.
When a Missed Payment Actually Becomes a Default
Missing one payment doesn’t automatically blow up the loan. Your plan administrator can offer a cure period to catch up, but that window has a hard ceiling under IRS rules: it cannot extend past the last day of the calendar quarter after the quarter in which you missed the payment.1Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period Miss a July payment and the latest the cure period can run is December 31. Some plans shorten that window; some don’t offer one at all. Check your plan document.
If the payment still isn’t made by the end of the cure period, the entire remaining loan balance becomes what the IRS calls a “deemed distribution.” The agency treats it as though the plan paid you the money in a lump sum on the date of the failure.2eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions No money physically moves. The loan balance still sits inside the plan. But for tax purposes, you received it.
The Federal Income Tax Hit
The deemed distribution gets added to your other income for the year. Because traditional 401k contributions went in pre-tax, the IRS now collects the tax you originally deferred, at ordinary rates ranging from 10 to 37 percent for 2026 depending on your total taxable income.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
The hit is usually larger than people expect because the distribution stacks on top of your wages. Someone earning $80,000 who defaults on a $30,000 loan isn’t taxed on $30,000 in isolation. That $30,000 pushes total income to $110,000, and the portion above the 22 percent bracket threshold ($50,400 for single filers in 2026) gets taxed at 24 percent.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 A default can bump you into a bracket you’d never otherwise reach.
If the loan came from a Roth 401k balance, the math is softer. Your Roth contributions were already taxed, so only the earnings portion of the deemed distribution gets added to gross income. The contribution portion comes out tax-free.4Internal Revenue Service. Retirement Plans FAQs on Designated Roth Accounts
State income tax applies in most states on top of the federal bill. Eight states have no individual income tax, so residents there owe nothing extra. Everywhere else, state rates on ordinary income reach as high as 13.3 percent at the top. For higher earners in high-tax states, the combined federal and state tax on a defaulted balance can approach half the loan.
The 10 Percent Early Withdrawal Penalty
If you’re under age 59½ when the default happens, the deemed distribution also triggers an additional 10 percent tax.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts On a $25,000 default, that’s $2,500 on top of the income tax, as a separate line on your return.
Several exceptions can wipe the penalty out:
- You separated from the employer sponsoring the plan during or after the year you turned 55. Public safety employees of state or local governments qualify at age 50.
- You meet the IRS definition of total and permanent disability.
- You had unreimbursed medical expenses above 7.5 percent of adjusted gross income; the portion of the distribution up to that excess is exempt.
- You’re taking substantially equal periodic payments over your life expectancy, though this rarely fits a one-time default.
Each exception is claimed on Form 5329 when you file. The penalty applies by default unless you affirmatively claim one.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
The Double-Taxation Trap
Here’s the piece that catches people years later. Because a deemed distribution doesn’t physically remove money from the plan, your old loan balance is still sitting in your account. You paid tax on it in the year you defaulted. But when you eventually take a real distribution from that account in retirement, the plan will report the whole balance as taxable unless you’ve tracked your basis.
Late repayments on the loan after the default do increase your cost basis in the plan, so the repaid amounts won’t be taxed again when you eventually withdraw.7Internal Revenue Service. Retirement Plans FAQs Regarding Loans The catch: you have to track that basis yourself on Form 8606 and keep the records for what might be decades. Lose the paper trail and you’ll pay tax twice on the same money. The IRS does not automatically remember a deemed distribution from years earlier when your plan issues a 1099-R for a later withdrawal.
A deemed distribution also cannot be rolled over to an IRA or another employer plan, because no money actually left the plan.8Internal Revenue Service. Plan Loan Failures and Deemed Distributions You can’t undo the tax hit by moving the money. The only way to build basis and protect against double taxation is to keep making payments on the original loan if your plan allows it.
If You Defaulted Because You Left the Job
When the default happens because you left your employer or the plan terminated, you’re usually dealing with a loan offset rather than a deemed distribution. The administrator subtracts the unpaid balance from your account and reports it as an actual distribution.9Internal Revenue Service. Plan Loan Offsets The money physically comes out. Your final statement will show the starting balance, the offset, and whatever cash is left.
That difference matters, because an offset amount is an eligible rollover distribution. You can erase the tax bill entirely by depositing an equivalent amount of cash into an IRA or a new employer plan. When the offset qualifies as a “qualified plan loan offset” (which it typically does if it arose from separation or plan termination), you have until the due date of that year’s federal return, including extensions, to complete the rollover.9Internal Revenue Service. Plan Loan Offsets File for a six-month extension and your deadline moves from mid-April to mid-October.
The money has to come from your own pocket. The plan already zeroed out the loan, so there’s nothing for it to send you. Replace the full offset amount by the deadline and the default is treated as though it never happened for tax purposes. Replace only part, and you owe tax (and potentially the 10 percent penalty) on whatever’s left uncovered.
If you also received a cash distribution alongside the offset, the plan withheld 20 percent of the cash portion for federal income tax, and the standard 60-day rollover window applies to that cash rather than the extended deadline.9Internal Revenue Service. Plan Loan Offsets Miss 60 days and the cash is permanently taxable.
Situations That Pause the Loan Without Triggering a Default
Two circumstances let you stop paying temporarily without the IRS treating it as default. If you take a leave of absence and your pay drops below what the installments require, the plan can suspend repayments for up to one year. The loan term itself doesn’t stretch, though, so your remaining payments grow to make up the gap.10Internal Revenue Service. Retirement Topics – Loans
Active-duty military service gets better treatment. Payments can be suspended for the entire period of active duty, and the repayment period is extended by the same length of time. An 18-month deployment adds 18 months to the original term.
How the Default Shows Up on Your Tax Forms
The plan reports the event on Form 1099-R, which you’ll get by January 31 of the year after the default. Box 7 carries the code that tells the IRS what happened: Code L for a deemed distribution (you defaulted while still employed and the loan stayed on the plan’s books), or Code M for a qualified plan loan offset (the plan reduced your account to cover the balance, usually after you left). A secondary code indicates your age and distribution type for penalty purposes.11Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 Box 1 shows the gross distribution; Box 2a shows the taxable amount. Both figures go on the pensions and annuities line of your Form 1040.
Form 5329 is where the 10 percent penalty either gets paid or gets waived through an exception code. Getting that form wrong is the fastest way to either overpay or trigger an IRS notice, so match the exception code carefully to your situation.
What a Default Won’t Do, and What It Actually Costs
Your credit score is safe. A 401k loan is borrowing from your own savings, not from a lender, so it never appears on your credit report. A default won’t show up in a credit check or affect a future mortgage or car loan application.
The real cost is the hole it leaves in your retirement. The defaulted amount is permanently gone from the tax-advantaged account where it was compounding, and you can’t contribute extra to catch up because annual contribution limits still apply. A $20,000 default at age 35, assuming a 7 percent average annual return, represents roughly $150,000 in lost retirement savings by age 65. That’s the bill the tax code doesn’t send you, and it’s usually the biggest one.