When borrowers default on 401(K) loans, they must pay regular income tax on the amount defaulted, and they are subject to a 10 percent federal tax penalty unless they qualify for an exemption, according to Zacks. Borrowers in some states must also pay state income tax on the amount defaulted.
401(K) loan defaults do not affect the borrower's credit rating, Zacks notes. Since the borrower is taking the loan from himself instead of a third party, the default is not reported to credit bureaus. 401(K) loans are repaid through payroll deductions. Most defaults occur due to job losses. When a borrower loses his job, he is required to repay the full outstanding balance, typically within 60 days. A sum of 80 percent of borrowers who lose their jobs do not repay the defaulted amount within the time limit, resulting in default, according to Zacks. The borrowers in default then receive a form 1099 from the 401(K) plan administration showing the defaulted amount, which they must declare as income on their tax returns.
There are several exceptions to the 10 percent early-withdrawal penalty, such as death, total and permanent disability, separation of service if over the age of 55, or if the borrower incurs medical bills that are more than 10 percent of his adjusted gross income during the year of the distribution, notes the IRS.