401K Loan Default: When is a disbursement not a disbursement?

July 2, 2009 8:22 AM

I discovered today that I have defaulted on a 401K loan in the amount of $3,896.31 ... help me figure out what the penalties will be & if the confused-sounding rep at Fidelity really knew what she was talking about.

I discovered today that I have defaulted on a 401K loan in the amount of $3,896.31 due to a combination of Fidelity being inept (they sent the notice to an incorrectly spelled street address) and my HR dept. giving me bad info (they told me the loan would be suspended while I was out on FMLA, but it was not). Fidelity informs me that
a) my payroll deduction payments will stop and cannot be restarted - to repay now I'll need to pay by coupon/check;
b) my defaulted loan will continue to accrue interest until paid off;
c) even if I pay it off within 60 days of the date of default (June 30th), I'll still have to pay the IRS penalties & the amount will still count as part of my taxable income.

I know you are not my tax professional but I don't have a tax professional, and can't afford at this moment to hire one, so you'll have to do.

1) Is the info I got from Fidelity correct? I'm a bit puzzled that it will both be considered a disbursement and still need to be repaid with interest. That seems like double dipping to me. I have previously (many years ago) had a 401k loan turn into a disbursement (due to end of employment) and it was just a disbursement - there was never a demand I also repay.

2) Can you help me calculate what my penalty payment will be (not counting the additional tax I'd need to pay with amount as part of my taxable income)? Will it be a flat 30%, or is it more complex than that.

3) I am expecting a large insurance settlement within the next few months. This money will not be taxable. If I put some of this not-taxable money into, say, an IRA, what (if anything) will this do to offset the tax hit I'll take for this disbursement.

Again, I know you are not my tax professional. Our finances are very tight (what with FMLA and medical bills and so forth) until the claim settles, but if I can avoid penalties by repaying within 60 days, that will be another stick to use to encourage my attorney to get things wrapped up.

Other things you may need to know: I'm in the USA. I was on unpaid medical leave for 12 weeks but have now returned to work. My employment status has not changed.

Thank you for your help.

posted by anonymous to work & money (3 comments total)

As far as the taxes, I believe that there is a flat 10% penalty paid to the IRS then the loan is taxed as normal income. So you would add the 401k loan amount to your income at the end of the year and pay federal, state, and local taxes as if you had been paid that amount from a job or any other source.
posted by jefeweiss at 8:45 AM on July 2

It doesn't sound quite right to me. Once you are found in default of the loan, you owe taxes and penalty based on the loan balance at that time. At that point, it essentially becomes a withdrawal of that amount. If you continue to pay the loan back, it no longer enjoys favorable tax status. You would have done much better to cancel the loan and increase your 401(k) contribution which would be made in pre-tax dollars. I'm not a tax expert, but the idea that you should treat the loan balance as income and still make the same payments seems crazy. If you simply said that you wish to default permanently on the loan and make no payments, the tax consequence would be exactly the same, so I fail to see the value in making those payments, unless the payments are made on a pre-tax basis, which I doubt.

jefeweiss has it right. The penalty is 10% of the outstanding balance ($389.63) and the balance should be added to your gross income, to be taxed at whatever your marginal income tax rate is by both the feds and state.
posted by Lame_username at 10:32 AM on July 2

I would ask about having the loan un-defaulted.

If you were not properly notified and/or you can prove that your HR dept gave you bad info you might have a chance. Also, I don't know if your loan can be defaulted when you're on medical leave or not (it may depend on how your plan is set up, or there may be a law there somewhere).

You can always call Fidelity a few times in a row and have the same conversation with different reps. Average out all the answers and you'll get something close to the truth.
posted by powpow at 5:44 PM on July 2 [1 favorite has favorites]