If you cannot make the payments, the loan goes into default. Then it becomes a distribution from your 401(k), subject to income tax and penalty.

If you have medical expenses that exceed 7.5% of your income, then you can use this excess to offset the penalty (but not necessarily the income tax). You do not even have to itemize for this, but you need to keep your documentation because the IRS is likely to ask. For example (using made-up numbers) if your income is $30,000 for the year and the balance on your defaulted 401(k) loan was $12,000, and you had medical expenses (include your mileage to treatments!) of $6,000. Your total income would be $42,000, 7.5% of which is $3,150. The excess medical would be $2,850. The penalty on your 401(k) would have been $1,200. Using Form 5329 and your excess medical, you reduce the penalty to $915. This, again, doesn't matter if you itemize or not. But if you do have other things like mortgage interest, high state income taxes, or charitable contributions, the excess medical expense might also help decrease your income taxes.

Hope that wasn't too confusing ...