What Are the 401k Loan Payback Rules?
Understand the payback rules for a 401k loan, including how they change with your employment, to avoid costly tax consequences and preserve retirement funds.
A 401k loan allows you to borrow from your retirement savings, but unlike a withdrawal, it is a loan that must be paid back into your account with interest. The regulations for repayment change depending on your employment status. Understanding these rules is important for anyone with a 401k loan, as failure to comply can lead to tax consequences and impact your long-term retirement goals.
Standard Repayment While Employed
When you take a 401k loan while employed, the repayment process is straightforward. Most plans mandate repayment through automatic payroll deductions, where funds are taken directly from your paycheck. These payments are made with after-tax dollars, meaning the money used for repayment has already been subject to income tax.
The repayment schedule is structured like a conventional loan, with payments required at least quarterly. Each payment consists of both principal and interest. The interest you pay does not go to a lender; instead, it is deposited back into your own 401k account. This means you are paying interest to yourself, which helps replenish the growth the borrowed funds might have otherwise generated.
IRS regulations require that 401k loans be repaid within five years. An exception exists for loans used to purchase a primary residence. In these cases, the repayment period can be extended, often to 10 or 15 years, depending on the terms of the 401k plan.
If you miss a payment, plans provide a “cure period” to fix the mistake before it triggers a default. The IRS allows this grace period to extend to the last day of the calendar quarter following the quarter in which the payment was missed. For example, if a payment due in February is missed, you have until the end of June to make up the payment and avoid default.
Repayment After Leaving Your Job
The rules for repaying a 401k loan change when you leave your job for any reason. Historically, borrowers faced a short window, often just 60 days, to repay the entire outstanding loan balance.
A shift occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which created a longer timeline for repayment. Under current rules, if you leave your job with an outstanding 401k loan, you have until the due date of your federal income tax return for that year, including extensions, to repay the loan. For instance, if your employment ended in 2024, you would have until April 15, 2025, or as late as October 15, 2025, if you file for a tax extension.
You have two primary options to avoid default. The most direct method is to repay the entire outstanding loan balance with cash from another source. This action satisfies the loan obligation and avoids any tax penalties.
The second option is a “qualified plan loan offset” rollover. This allows you to roll over the outstanding loan amount to another eligible retirement plan, such as an IRA or a new employer’s 401k. To do this, you must use funds equal to the loan balance from an outside source and deposit that amount into the new retirement account. As long as this is completed by the tax-filing deadline, it prevents the loan from being treated as a taxable distribution.
Consequences of Loan Default
Failing to repay a 401k loan according to the rules results in a default, which carries financial repercussions. When a loan defaults, the entire outstanding balance is treated by the IRS as a “deemed distribution.” This means the loan amount is reclassified as a taxable withdrawal from your retirement account, even though you already received the cash. Your employer will report this event to you and the IRS on Form 1099-R.
First, the outstanding loan balance is added to your gross income for the year and taxed at your ordinary income tax rates. For example, if you are in the 22% federal tax bracket and default on a $15,000 loan, you would owe an additional $3,300 in federal income taxes, plus any applicable state taxes.
Second, if you are under age 59 ½ at the time of the default, you will face a 10% early withdrawal penalty on the loan balance. In the previous example of a $15,000 default, this would add another $1,500 to your tax liability, bringing the total immediate cost to $4,800.
A loan default also leads to a permanent reduction in your retirement savings. The defaulted amount is removed from your account balance in a “loan offset.” This money is gone for good and cannot be repaid later to restore your balance, making the loss to your retirement nest egg permanent.