Taxation on 401k Loan Default

Submitted by Brian Stormont on Thu, 2023-11-02 21:00

Hi all,

I called in with a client to the Fidelity 401k department on a 401k plan with a Fortune 500 company. We were asking about some of the rules around the Loan Provisions and the call center rep said something that was new to me. He said if the client took a loan this year he could pay it off over, up to 5 years (so far so good). If a year from now, should the client no longer be working there, they could keep paying the loan, which is nice (also knew this). However, the rep said if the client defaulted on the loan, the loan would be taxable in the year of the loan request, so in 2023, not in the year of default. Have you run into that rule?



Submitted by David Mertz on Thu, 2023-11-02 21:54

  • Unless there was some miscommunication, the rep seems misinformed in several respects.  A default results in a taxable deemed distribution for the year in which the default is declared.  There is no retroactive taxation to an earlier year and only the outstanding balance becomes taxable.  Perhaps the rep is confusing this with the recapture of early-distribution penalties when one modifies a series of substantially equal periodic payments, which has nothing to do with this.
  • A deemed distribution does not satisfy the loan, it only makes the outstanding balance taxable.  The client would still have to pay off the loan.  Subsequent repayments would become after-tax basis in the plan.
  • If after separation from service the client is unable to make the loan payments within the period beginning on the date of the employee’s severance from employment and ending on the first anniversary of that date, the client should be able to request an offset distribution.  With a qualified plan loan offset distribution the loan is paid off with funds from the 401(k) rather than defaulting and the client would have until the due date of the tax return for the year in which the offset distribution occurs to come up with the funds to do a rollover of some or all of the offset distribution which would continue to defer taxes and avoid a potential early-distribution penalty on the portion rolled over.
  • Given the seemingly incorrect information provided by the first rep, it might make sense to go over this again with a different Fidelity rep.


Submitted by Brian Stormont on Thu, 2023-11-02 23:04

Yeah, it all seemed a little odd.  Anyway, thank you!



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