MMC Benefits Handbook
Consequences of Loan Default
If your loan goes into default and you do not make up the payments then the Internal Revenue Service requires that a default be declared no later than the last business day of the calendar quarter following the calendar quarter in which your first missed payment was due. If you do not repay your loan(s), the outstanding loan balance, plus accrued interest, may be treated as a taxable distribution from your account reducing your vested account balance by the outstanding loan amount with the outstanding loan amount (plus accrued interest) being subject to income tax including an additional 10% Federal early withdrawal tax if you are under age 59-1/2 unless an Internal Revenue Service exception applies to you.
In addition, the outstanding loan balance will be treated as a distribution and continue to be taken into account when determining the number of loans you have outstanding and the amount available for a new loan. This can restrict your ability to take another loan in the future.