In cases of a default, the loan amount outstanding is considered a premature 401k distribution on which you will owe income tax plus a 10% penalty if you are younger than 59 1/2.
If the plan allows a “cure period,” payments made to bring the loan current before the end of the “cure period” must include all accrued interest as well as principal owed on the “cure date.”
The question relates more to late payments and at what point would the loan be considered in default and subject to the deemed premature distribution.
There would be no “late payment penalty” provided the loan was “cured” timely.
Here is the part of Internal Revenue Regulations pertaining to this issue:
(a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)(C) will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. “Nabers Group Comment – (Approximately 3 months)”
(b) Amount of deemed distribution. The amount of the deemed distribution equals the entire outstanding balance of the loan (including accrued interest) at the time of such failure.
(c) Example. The following example illustrates the rules in paragraphs (a) and (b) of this Q&A-10 and is based upon the assumptions described in the introductory text of this section:
Example. (i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.
(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)(C), the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.
Q-14: How is the amount includible in income as a result of a deemed distribution under section 72(p) required to be reported?
A-14: The amount includible in income as a result of a deemed distribution under section 72(p) is required to be reported on Form 1099-R (or any other form prescribed by the Commissioner).
Your Solo 401(k) plans state that within 10 days of the first missed payment, the administrator must notifiy the participant in writing that the loan will be in default if it is not cured by the end of the quarter following the quarter that the first payment was missed. This is the longest cure period available under these regulations.