You are expected to either pay the loan back or consider the loan to be a distribution.

As you stated it is not possible for many people who are laid off to repay an outstanding loan. Here are the three options.

First, pay the loan back. If you have the money it is best to pay the loan back to avoid taxes and penalties. This way all money goes back to you.

Second, if you can't pay the loan back it is possible that your employer will allow you to continue to pay even though you are not an employee, so if you can afford the loan payments you can avoid taxes and penalties by continuing with your loan payments. However, very few employers will facilitate this process so chances are this will not be an option. Still, you can ask.

Finally, you can not pay it back. After a period of time (90 days) it will be considered to be in default but don't worry, this is not a credit report issue. The record keeper will default the loan which means they will consider the loan to be abandoned and issue a 1099 to you at the end of the year. In effect they are changing the distribution to be a taxable distribution rather than a nontaxable loan. You will have to claim this amount on your tax return and pay taxes at your normal tax rate. So hypothetically if you pay 25% in taxes and your outstanding loan was $10000 you would owe $2500 more at tax time. Not only that, if you are less than 59.5 years old you will also be assessed a 10% excise tax on the outstanding amount, or another $1000 in our example. That's $3500 total, still better than $10000.

If you lose your job, you can cash out your 401k completely. You can then settle the loan and pay taxes on the whole kit and kaboodle, or roll over the balance into an IRA or other investment vehicle and only pay taxes on the amount that covered the loan.