The rules for a 401(k) loan are set partly by federal law and partly by your specific plan document. Federal law caps what you can borrow, sets the repayment window, and dictates the tax consequences if things go wrong. Your plan decides whether loans are even offered, how many you can have at once, what fees apply, and whether missed payments get a grace period. Here is how the 401(k) loan rules work in practice, from the borrowing limit through the tax hit if a loan defaults.
How Much You Can Borrow
Federal law caps a 401(k) loan at the lesser of $50,000 or 50% of your vested account balance. The $50,000 figure is written into the tax code and is not indexed for inflation.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Your vested balance is the portion you fully own, which excludes employer contributions that have not finished vesting.
Smaller accounts get a floor. You can borrow up to $10,000 even if that exceeds half your vested balance, so someone with a $15,000 vested balance can borrow $10,000 rather than $7,500.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
If you have borrowed from the plan in the past 12 months, the $50,000 cap shrinks. It is reduced by the difference between your highest outstanding loan balance during the prior 12 months and your current balance, and then your current balance is subtracted again. This blocks the trick of paying a loan down and immediately re-borrowing the full amount.2Internal Revenue Service. Issue Snapshot – Borrowing Limits for Participants With Multiple Plan Loans
Say you borrowed $40,000 two years ago and paid it down to $25,000, with a peak balance of $32,000 in the last 12 months. The reduction is $7,000 ($32,000 minus $25,000). Your adjusted cap becomes $43,000, and after subtracting the $25,000 still outstanding, the most you can borrow now is $18,000.2Internal Revenue Service. Issue Snapshot – Borrowing Limits for Participants With Multiple Plan Loans
Federal law does not limit the number of loans you can have at once, but your plan document might. When multiple loans are allowed, each must independently meet the repayment rules, and all loans across your employer’s plans (including related companies in a controlled group) count toward the same dollar cap.2Internal Revenue Service. Issue Snapshot – Borrowing Limits for Participants With Multiple Plan Loans
Interest, Fees, and What the Loan Really Costs
Most plans set the interest rate at the prime rate plus one percentage point. You pay that interest to yourself, since it flows back into your own account. That sounds like a free lunch, but it isn’t. The dollars you borrow leave whatever investments they were sitting in, so you forfeit any market returns those funds would have earned during the loan term. If the market outperforms your loan’s rate, you come out behind.
Many plans also charge an origination fee at the start of the loan and an annual maintenance fee while it is outstanding. These come straight from your account balance and vary by provider. On a small loan, they can add real cost relative to the amount borrowed, so check your plan’s fee schedule before applying.
Repayment Terms
A general-purpose 401(k) loan must be repaid within five years. Payments must be substantially equal, cover both principal and interest, and occur at least quarterly.3Internal Revenue Service. Retirement Plans FAQs Regarding Loans Most employers automate this through payroll deductions each pay period, which is well above the quarterly minimum.
Loans used to buy your primary residence are exempt from the five-year cap and can run longer, based on what your plan document allows. Federal law sets no maximum term for these loans.4Internal Revenue Service. Retirement Topics – Plan Loans
Repayments come out of your paycheck after tax. Since the money originally went into your 401(k) pre-tax and now returns as post-tax income, the interest you pay gets taxed twice: once when you earn the money used to pay it, and again when you withdraw it in retirement. The principal is not truly double-taxed, because you received it tax-free when you borrowed. But the interest is new money going in without a deduction, and it will still be taxed on the way out.
Federal law neither requires nor prohibits prepayment penalties on 401(k) loans. Whether you can pay off early without a charge depends on your plan. Most plans do allow it.
When Spousal Consent Is Required
Most standalone 401(k) and profit-sharing plans do not require your spouse to sign off on a loan. That exemption only applies when three conditions are all met: the plan pays the full death benefit to the surviving spouse by default, the plan does not offer a life annuity payout, and the plan has never received a direct transfer from a plan that was required to provide a survivor annuity. When any of those fails, spousal consent is required for loans over $5,000.4Internal Revenue Service. Retirement Topics – Plan Loans
Written spousal consent is always required for defined benefit plans, defined contribution plans subject to the minimum funding rules, and any 401(k) that received a transfer from a plan governed by the survivor annuity rules.5eCFR. 26 CFR 1.401(a)-20 – Requirements of Qualified Joint and Survivor Annuity and Qualified Preretirement Survivor Annuity
Leaves of Absence and Military Service
If you take a non-military leave, your plan can suspend loan payments for up to one year. When you come back, you make up the missed amounts by increasing each remaining payment or paying a lump sum at the end. The total loan term still cannot go beyond the original five-year deadline.3Internal Revenue Service. Retirement Plans FAQs Regarding Loans
Active-duty military service is treated more generously. Payments can be suspended for the entire duration of active duty, and the maximum repayment term extends by the length of the service. Two years of active duty turns a five-year loan into a seven-year loan.6Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA
Interest accrued during active duty is generally capped at 6%. To get that rate, send a copy of your military orders to your plan sponsor and specifically request the lower rate.6Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA
Missing a Payment
A single missed payment does not automatically default the loan. If your plan document provides for it, you get a cure period running to the end of the calendar quarter after the quarter in which the payment was due. Miss a February payment, and you have until June 30 to catch up. Miss an October payment, and you have until March 31 of the following year.7Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period
Two catches. The cure period is optional, so it only exists if your plan writes it in. And if you don’t catch up in time, the consequence is not just the missed payment. The entire outstanding balance, plus accrued interest, becomes a deemed distribution.7Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period
Leaving Your Job With a Loan Outstanding
This is where borrowers get caught. When you separate from your employer, the plan can demand full repayment of the outstanding balance. If you cannot pay, the plan reduces your account by the loan amount. This is a plan loan offset, and it is treated as an actual distribution rather than a deemed one.8Internal Revenue Service. Plan Loan Offsets
The same thing happens if the employer terminates the plan entirely. The plan sponsor can require immediate repayment, and any unpaid balance is offset and reported as a distribution on Form 1099-R.4Internal Revenue Service. Retirement Topics – Plan Loans
The one break the law provides: a plan loan offset triggered by job separation or plan termination is a “qualified plan loan offset amount,” or QPLO. You can roll the offset amount into an IRA or another eligible retirement plan by the due date, including extensions, of your federal tax return for the year the offset happens.9Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust Roll it over in time and you avoid both income tax and the early withdrawal penalty. Miss the deadline, and the full amount becomes taxable income for the year.
This extended rollover window is only available for those two triggers. If your loan defaults while you are still employed because you stopped making payments, the resulting deemed distribution cannot be rolled over at all.8Internal Revenue Service. Plan Loan Offsets
The Tax Bill on a Defaulted Loan
When a 401(k) loan defaults, whether from uncured missed payments or an unpaid balance after leaving your job, the outstanding amount is reported to the IRS as taxable income on Form 1099-R.10Internal Revenue Service. Instructions for Forms 1099-R and 5498 It gets added to your gross income for the year and taxed at your ordinary federal and state rates.
If you are under age 59½, a 10% early withdrawal penalty applies on top of ordinary income tax.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts For someone in the 22% federal bracket with a $10,000 defaulted balance, that’s $2,200 in income tax plus $1,000 in penalty, or $3,200 before state tax. The account itself is also permanently smaller, so the lost compounding over the years ahead can outweigh the immediate tax hit.
A few narrow exceptions to the 10% penalty apply. You won’t owe it if you separated from your employer during or after the year you turned 55, if you became disabled, or if the distribution is part of a series of substantially equal periodic payments over your life expectancy.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Most people who default while still working won’t fit any of them.