401(k) Loan

A 401(k) loan is a loan a participant takes from their own vested balance in a workplace retirement plan, secured by that balance and repaid with interest that goes back into the participant's own account rather than to a lender. The rules live at Internal Revenue Code section 72(p), and the IRS calls these participant loans or plan loans — "401(k) loan" is the consumer name and the one people search for, but plan documents and IRS guidance use the formal terms.

The structural point that distinguishes it from every other way of getting at retirement money is that a loan is not a distribution. Nothing is included in income, no early withdrawal penalty applies, and the balance is expected to be restored. That also means the two ways a loan goes wrong are the only places tax enters the picture — and they are legally different from each other in ways that matter a great deal. Note also that this is a plan feature rather than a universal right: loans are prohibited from IRAs and IRA-based plans including SEP, SARSEP, and SIMPLE IRAs, and a 401(k) or 403(b) plan may simply choose not to offer them.

The limit, stated precisely. The maximum is the lesser of two amounts: $50,000, or 50% of the vested account balance. There is a statutory alternative that lets a plan permit borrowing up to $10,000 even where that exceeds half the balance, though many plans do not adopt it. The $50,000 figure is set in the statute and is not among the retirement figures the IRS adjusts annually. And it is not measured against your current loan balance — it is reduced by the highest outstanding balance of plan loans during the one-year period ending the day before the new loan, net of what is outstanding on the day of the loan. That is the provision that catches serial borrowers: repaying an old loan does not immediately restore full capacity, because the repaid loan's peak still counts for a year.

One thing to actively discard: the temporary CARES Act relief that raised the limit to the lesser of $100,000 or 100% of the vested balance has expired. It is still all over older articles and, unfortunately, still repeated in conversation.

The repayment terms. A loan must be repaid within five years, in substantially level amortized payments made at least quarterly. A loan used to acquire a principal residence may run longer. Interest is charged at a commercially reasonable rate and paid into your own account, which is the feature people rightly like — you are your own lender.

The two failure modes, which are not the same event. This distinction is the most load-bearing content on the page, and flattening it into "if you default you owe tax" gets both halves wrong.

A missed payment starts a cure period running to the last day of the calendar quarter following the quarter in which the payment was due. Miss that and you have a deemed distribution under section 72(p): the outstanding balance is included in income, the additional 10% tax applies if you are under 59½ with no exception, it is not eligible for rollover — so there is no way to fix it by finding the cash — and, critically, the loan legally still exists. You owe the tax and you still owe the plan. It is the worst outcome available here.

Separation from service, or the plan terminating, produces a plan loan offset instead: the plan reduces your account balance by the unpaid loan, which is an actual distribution and therefore is eligible for rollover. You can make yourself whole by rolling an equivalent amount of your own money into an IRA or another plan — normally within 60 days. But a qualified plan loan offset, meaning one arising from severance from employment or plan termination and occurring within one year of the severance, gets until the due date of your tax return including extensions — a change made by the Tax Cuts and Jobs Act and implemented in final regulations. That can be well over a year of breathing room instead of 60 days. If the plan waits more than a year after severance to process the offset, it is not a qualified plan loan offset and the 60-day window applies again.

The real cost, which is not the interest rate. Two quieter effects do more damage than the rate. First, repayments come out of take-home pay — after-tax dollars — going into a pre-tax account, where they will be taxed again as ordinary income when eventually distributed. Second, loan repayments are not contributions, so they attract no employer match — matching is made on elective deferrals, and a repayment is not one. Whether that costs anything depends on the plan: some plans let a participant keep deferring alongside the repayments, so the match continues for anyone who can afford both, while other plans bar new contributions until the loan is repaid, which makes the lost match unavoidable rather than a budgeting choice. That is a question worth asking before signing, because it can be the single largest cost of the loan. Add the growth the borrowed balance did not earn while it was out of the market, and the cost of a "cheap" loan is mostly invisible on the loan statement. Spousal consent, for what it is worth, is a plan-level requirement in some plans rather than a federal rule for 401(k) loans.

The sequence: confirm the plan offers loans; compute the maximum; sign the loan agreement and amortization schedule; repay through payroll deduction at least quarterly for up to five years; and if you separate before it is repaid, decide whether to roll the offset amount.

A hypothetical example of the twelve-month lookback, which is the part almost nobody expects. Marcus has a $90,000 vested balance. Half of that is $45,000, which is less than $50,000, so ordinarily his maximum would be $45,000. But he repaid a $20,000 loan two months ago. His $50,000 ceiling is reduced by the highest balance outstanding in the past twelve months less what is outstanding today: $50,000 − $20,000 = $30,000. His maximum is the lesser of that $30,000 and the $45,000 half-balance figure, so $30,000 — not $45,000, and not $50,000, even though he currently owes nothing.

Now the separation case. Suppose Marcus borrows the $30,000, repays it down to $18,000, and then changes jobs. The plan offsets his account by $18,000. If that offset qualifies as a qualified plan loan offset, he can roll $18,000 of his own money into an IRA by his tax return due date including extensions and owe nothing. If he does not, the $18,000 is ordinary income: at a 22% marginal rate that is $18,000 × 0.22 = $3,960, plus the additional 10% tax of $18,000 × 0.10 = $1,800 because he is under 59½, for $3,960 + $1,800 = $5,760 in federal tax on money he had already repaid most of.

Pros

• No tax and no early withdrawal penalty while the loan is performing, unlike any distribution route.
• Interest is paid into your own account rather than to a lender.
• No credit check, and no effect on your credit report — plan loans are not reported to the credit bureaus, and neither is a default, so the consequences of failing to repay are tax consequences rather than credit ones.
• Rates are typically well below unsecured consumer credit, and the money is usually available quickly.
• Unlike a hardship distribution, the balance is meant to be restored — the retirement money is borrowed, not spent.

Cons

• Repayments come from after-tax pay into a pre-tax account, so those dollars are taxed again on eventual distribution.
• Repayments are not contributions and earn no employer match; some plans go further and block new contributions until the loan is repaid, which forfeits the match outright for the life of the loan.
• The borrowed balance is out of the market, so the opportunity cost is real even though it never appears on a statement.
• An uncured missed payment becomes a deemed distribution that is taxable, cannot be rolled over, and leaves the loan still outstanding.
• Leaving your job accelerates the whole thing, which turns a manageable loan into an urgent tax problem at the least convenient time.
• It is a plan option, and IRAs cannot do this at all.