Q: I took out a loan against my 401(k) retirement account. Now I've been laid off. If I default on the loan, will it affect my credit score? I know that I will pay a 10% penalty and will have to declare the loan as income on my tax return.
Employers do not report defaults to the credit bureaus, so your credit score will not be affected. Instead, the loan becomes a tax liability. "It is deemed a distribution from the plan," explains David Wray, president of the Profit Sharing/401(k) Council of America, which represents companies that sponsor profit-sharing plans.
If you leave your job for any reason, your 401(k) loan is usually due in full within 60 days. If you can't repay it, you will receive a Form 1099 (and the IRS will receive a copy) that shows the amount on which you owe taxes. You have until April 15 of the following year to pay the tax. Employees 55 and older who take a 401(k) distribution because they have lost their job do not owe the 10% early-withdrawal penalty.
Wray cautions workers who are considering taking a 401(k) loan to be aware that should they default, 40% or more of the money could go to the government, assuming 25% in federal taxes and 5% in state taxes, plus the 10% early-withdrawal penalty. So you might net only $4,500 from a typical $7,500 loan.