401k loan default

[Guest hsocwarren]

If I decide to retire and withdraw $50000 in 401k funds at age 59 1/2, I understand that 20% will be withheld for taxes, leaving me $40000 for the remainder of the year. However, If I take out a 401k loan for $50000, then after attaining age 59 1/2 I default on the loan, will I have had full use of the $50000, without any pre-paid taxes or penalties??

[masteff]

If I decide to retire and withdraw $50000 in 401k funds at age 59 1/2, I understand that 20% will be withheld for taxes, leaving me $40000 for the remainder of the year. However, If I take out a 401k loan for $50000, then after attaining age 59 1/2 I default on the loan, will I have had full use of the $50000, without any pre-paid taxes or penalties??

The loan is taxable income in the year it's defaulted. So while you'd be over 59 1/2 so no early withdrawal penalty and no withholding at the time that the money comes out of the plan, you would still need money to pay income tax on the defaulted amount when you file your taxes April 15th. Ask your plan for a copy of the "special tax notice" which contains some useful info. Also IRS publication 575 has some additional info.

[J Simmons]

and, the trustees of the 401k plan would likely be legally obligated to pursue repayment from you even though it was taxable income to you in the year of default. Repayment would establish tax basis, so you wouldn't have to pay tax a second time. But you'd lose the advantage of paying the income on that $50,000 later rather than now.

Another angle might be to take a regular distribution (if you've experienced an event that, under the terms of the plan, permit payout), elect to roll it directly into an IRA, and then withdraw from the IRA. Still taxable, but you avoid the 20% withholding.

[masteff]

the trustees of the 401k plan would likely be legally obligated to pursue repayment

Actually, no, not for a former employee. (This is from experience, I worked in a large corporation with four 401(k) plans w/ assets over $800 million.) The standard loan doc typically covers that repayment will be by payroll deduct, else EE must make payments according to terms of loan, if payments are missed then loan will be defaulted. No collection procedure, no burden on plan to attempt to collect. Only real barrier to EE is having to payoff defaulted loan if wants to take a new one.

[rcline46]

What everyone is saying is that a DEFAULTED loan is not a repaid loan. It is still owed to the plan and is still the debt of the participant. Actually, once a loan is defaulted, at some point in time it becomes a DEEMED distribution which means taxes are due, but you still owe the loan. YOu need a distributable event to distribute the loan so that it is cancelled.

In other words, don't do it. If you want $50,000, gross it up for the taxes. Or do the IRA bit.