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What are the consequences of defaulting on a 401(k) loan?

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Quick Answer

The consequences of defaulting on a loan from a 401(k) retirement account include taxes and possible penalties that the borrower owes to the Internal Revenue Service, reports Forbes. Additionally, the borrower loses the retirement savings and all future compounded profits from the amount of the loan.

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Full Answer

When employees default on all or part of a 401(k) loan, the IRS considers the entire outstanding balance of the loan to be a distribution for tax purposes, explains Fox Business. Borrowers lose the tax benefit of the 401(k) and must pay standard income tax on the amount that they still owe. Additionally, if they are under 59 1/2 years old, they must pay an additional early distribution penalty tax of 10 percent of the outstanding loan balance. The 10-percent penalty tax may not apply if the borrower qualifies for an IRS hardship distribution. Defaults of 401(k) loans do not hurt borrowers' credit, as employers do not inform the credit bureaus about loan defaults, states Kiplinger.

Loans from 401(k) accounts have borrowing limits, short repayment periods, management expenses and the risk of owing the entire amount when the borrower loses a job, cautions U.S. News & World Report. Additionally, taking out a 401(k) loan reduces borrowers' retirement savings. Before risking the consequences of a 401(k) loan default, those who need emergency funds should look into other sources such as banks, credit card companies and home equity lines, advises Forbes.

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