No. of Recommendations: 2
Yikes, I know you get taxed as normal income is all I know.

Actually, it can be worse than that. The defaulted loan amount is counted as a distribution. 401(k) distributions are taxed at your marginal rate (both federal and state, as applicable), plus, if you are under 59 1/2, there is a 10% Federal penalty, and some states also have penalties.

As an example, in CA, if you default on $10,000 outstanding balance you could owe $4,680 in taxes:

25% Federal tax (assuming 25% marginal rate)
10% Federal penalty
9.3% CA tax (assuming 9.3% marginal rate)
2.5% CA penalty

46.8% Totsl tax * 10,000 = $4,680

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