What to Know About the 401k Loan Rules

A 401k loan allows a retirement plan participant to borrow money from their own account balance. This is distinct from a conventional loan because it does not involve a third-party lender or a credit check. Instead, the participant accesses their own retirement savings with a formal agreement to repay the funds. The regulations for these transactions are from the Internal Revenue Service (IRS), but the availability and specific terms are dictated by the individual’s 401k plan.

Loan Eligibility and Limits

The ability to take a loan is not a universal feature of all 401k plans; the employer’s plan document must explicitly permit them. If loans are allowed, their issuance is governed by IRS guidelines to distinguish them from taxable distributions. An individual’s eligibility to borrow is determined by their vested account balance, which is the portion of their retirement savings they own outright.

Federal regulations under Internal Revenue Code Section 72 set the maximum loan amount. A participant may borrow the lesser of $50,000 or 50% of their vested account balance. For example, a participant with a vested balance of $80,000 could borrow a maximum of $40,000, while a participant with a vested balance of $150,000 would be capped at the $50,000 limit. This limit is reduced by the highest outstanding loan balance the participant had in the preceding 12 months.

A specific exception exists for participants with smaller balances. The rules permit a loan of up to $10,000, even if this amount exceeds the 50% threshold, provided the participant has at least a $10,000 vested balance. Beyond these IRS minimums, individual plans can impose their own, more restrictive rules, such as setting a minimum loan amount or limiting a participant to one outstanding loan at a time.

Some retirement plans also require spousal consent before a loan can be issued. This provision is intended to protect the financial interests of the non-participant spouse. When required, the plan will mandate that the participant’s spouse provide formal, often notarized, written consent to the loan.

Repayment Terms and Interest

The repayment structure for a 401k loan is clearly defined by federal law. The standard maximum repayment period for a general-purpose loan is five years from the date the loan is issued. Payments must be made in substantially level installments that include both principal and interest, and these payments must occur at least quarterly. Most plans require repayment through automatic payroll deductions, which reduces the risk of missed payments.

An exception to the five-year repayment rule exists for loans used to purchase a primary residence. If the loan proceeds are documented for this purpose, the plan may allow for a much longer repayment term, often extending to 15 years or more. The specific length of the term is determined by the provisions within the 401k plan document.

Interest must be charged on a 401k loan at a rate that is considered “commercially reasonable.” Plan administrators satisfy this requirement by pegging the loan rate to a benchmark, such as the prime rate plus one or two percentage points. The interest does not go to a bank; instead, it is paid directly back into the participant’s own 401k account with the principal repayments.

While paying interest to oneself may seem advantageous, the funds that are out on loan are not invested in the market. This means the participant forgoes any potential investment gains that could have been earned on that money during the loan period. This opportunity cost is a direct consequence of borrowing from the account.

Tax Consequences of a 401k Loan

When a 401k loan is taken and repaid according to all applicable rules, the proceeds are received by the participant tax-free. The transaction is treated as a loan, not a withdrawal, so it does not trigger immediate income taxes or penalties. This tax-neutral treatment is contingent upon adherence to the regulations regarding loan amounts and repayment schedules.

The interest paid on a 401k loan is not tax-deductible, even if the loan is used to purchase a primary residence. Furthermore, because loan repayments are made with after-tax dollars from a paycheck, this creates a form of double taxation. The money used to repay the loan has already been taxed, and it will be taxed again as ordinary income when withdrawn from the 401k during retirement.

If a participant fails to comply with the loan rules, the IRS reclassifies the transaction from a loan to a “deemed distribution.” This occurs if the loan amount exceeds the legal limits, or if payments are not made according to the required schedule. When a loan is deemed distributed, the outstanding balance is treated as a withdrawal from the 401k plan for tax purposes.

The financial impact of a deemed distribution can be substantial. The outstanding loan balance is included in the participant’s gross income for the year the default occurs and is subject to ordinary income taxes. If the participant is under age 59 ½, the amount is also subject to a 10% early withdrawal penalty. A deemed distribution is a tax event; for plan purposes, the loan may still be considered outstanding and require repayment.

Loan Default and Separation from Employment

The most common event that leads to a loan default is the failure to make a scheduled payment. IRS regulations provide a grace period, known as a “cure period,” which allows a participant to make up for missed payments. A borrower has until the last day of the calendar quarter following the quarter in which the first payment was missed to remit all overdue amounts and bring the loan current.

A more complex situation arises when a participant with an outstanding loan separates from their employer. Many plan documents contain a provision that accelerates the loan’s due date, requiring the outstanding balance to be repaid in full shortly after termination. If the participant cannot repay the loan, the plan will execute a “loan offset,” where the outstanding balance is subtracted from the participant’s vested account balance.

The Tax Cuts and Jobs Act of 2017 introduced a rule that provides relief in this scenario. When a loan is offset from an account due to separation from employment, that offset amount is considered a “qualified plan loan offset” (QPLO). The former employee has until their federal income tax filing deadline for the year of the offset, including extensions, to roll over the offset amount into an IRA or another qualified retirement plan.

For instance, if an employee leaves their job in July 2025 and their $20,000 loan balance is offset, they have until April 15, 2026, to deposit $20,000 into an IRA. If they file for a tax extension, this deadline moves to October 15, 2026. Successfully completing this rollover allows the participant to avoid paying income tax and the 10% early withdrawal penalty on the loan balance.