Many 401(k) plans let participants take loans against the funds in the portfolio. In some cases, loans are repaid via automatic payroll deductions, while in others you're responsible for sending in payments on a quarterly basis. If you leave your job, however, these loans must be repaid in full within a defined period. If you can't repay the balance within the required time span, it is recorded as a defaulted loan.
When Loans Become Distributions
When a loan isn't repaid within the required period, it's treated as a distribution from the plan. You'll get a 1099 form from the plan administrator documenting the amount that wasn't repaid, and the Internal Revenue Service receives a copy as well. While that failure to repay the loan won't negatively affect your credit score, you'll likely need to pay both income taxes and a penalty on the unpaid amount on your tax return. If you're younger than 59 1/2, you'll pay a 10 percent penalty off the top and owe taxes on the rest based on your individual tax bracket. The age limit is 55 if the default happens after you left your job, regardless of whether you left voluntarily. If you're younger than 55 you'll pay a 10 percent penalty off the top and owe taxes on the rest based on your individual tax bracket