A 401(k) loan is not taxed as income if you follow the IRS repayment rules, because the plan treats the money as a debt you owe yourself rather than a withdrawal. The question of whether 401(k) loans are taxed only turns into a yes if the loan falls out of compliance: miss the repayment schedule, or leave your job with an unpaid balance you don’t roll over, and the outstanding amount becomes ordinary income. If you’re under 59½, a 10% early-distribution penalty comes with it.
What Keeps a 401(k) Loan Tax-Free
Under 26 U.S.C. § 72(p), any amount you receive as a loan from a qualified employer plan is generally treated as a taxable distribution, but the statute carves out an exception for loans that stay within specific dollar limits and repayment rules.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Meet the requirements and the IRS treats the money as a debt obligation. You are legally bound to return the principal plus interest to your own account, so the proceeds are not counted as income in the year you receive them.
Three conditions do the work of keeping the loan tax-free.
First, the amount. The maximum you can borrow is the lesser of $50,000 or 50% of your vested account balance.2Internal Revenue Service. Retirement Topics – Plan Loans Some plans allow a floor of up to $10,000 even when that exceeds half of your vested balance, but plans are not required to include this provision.
Second, a written agreement. A valid loan must be documented in a legally enforceable agreement that spells out the repayment schedule, the interest rate, and the amount borrowed. The rate must be reasonable, comparable to what you would pay a commercial lender for a similar loan.3Internal Revenue Service. 401(k) Plan Fix-It Guide – Participant Loans Interest you pay flows back into your own retirement account.
Third, the repayment schedule. You must repay a general-purpose 401(k) loan within five years, in substantially equal installments of principal and interest, at least quarterly.2Internal Revenue Service. Retirement Topics – Plan Loans Balloon structures are not allowed. Loans used to buy a primary residence can run longer than five years, though the quarterly-payment and level-amortization rules still apply.4Internal Revenue Service. Retirement Plans FAQs Regarding Loans
Not every 401(k) offers loans at all. Plan sponsors decide whether to include the feature, so check your Summary Plan Description or ask your plan administrator before assuming you can borrow.2Internal Revenue Service. Retirement Topics – Plan Loans
When a 401(k) Loan Becomes Taxable
A deemed distribution happens when you fail to keep up with the required repayment schedule. Miss a payment and the plan may give you a cure period. The longest allowed extends through the last day of the calendar quarter after the quarter in which the payment was missed.5Internal Revenue Service. Issue Snapshot – Plan Loan Cure Period A payment missed in February gives you until June 30 to catch up. Miss that deadline and the entire outstanding balance is treated as a taxable distribution.
The unpaid balance is taxed as ordinary income. Federal rates in 2026 range from 10% to 37%, depending on your total taxable income.6Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 A borrower in the 22% bracket who defaults on a $10,000 balance would owe roughly $2,200 in federal income tax on that amount. If you are younger than 59½, the IRS adds a 10% early-distribution penalty on the taxable portion, bringing the total federal hit in that example to about $3,200.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
One wrinkle to be aware of. Even after a deemed distribution, you may still owe the loan balance to the plan. The tax event does not erase the debt; it simply means the IRS now treats the money as income. If you continue making payments afterward, those payments can increase your cost basis in the plan, which may reduce taxes on future withdrawals.
Roth 401(k) Loan Defaults
Loans funded from a designated Roth account are handled differently. Because Roth contributions were made with after-tax dollars, the portion of a deemed distribution attributable to your contributions is not taxed again. Only the earnings portion is included in gross income.7Internal Revenue Service. Retirement Plans FAQs on Designated Roth Accounts The split is based on the ratio of Roth contributions to the total Roth account balance at the time of the deemed distribution. If your Roth account holds $9,400 in contributions and $600 in earnings, roughly 94% of a deemed distribution would be tax-free and only the remaining 6% would be taxable.
Leaving Your Job With an Outstanding Loan
A plan loan offset happens when you separate from service or the plan terminates while you still owe a balance. The plan reduces your account by the unpaid loan amount, effectively using your retirement assets to pay off the debt. Unlike a deemed distribution, which can occur while you’re still employed, an offset is triggered by leaving the plan and is reported as an actual distribution.
The Tax Cuts and Jobs Act created a longer rollover window for these situations. If the offset qualifies as a “qualified plan loan offset,” meaning the loan was in good standing and the offset happened because you left your job or the plan ended, you have until your tax filing due date, including extensions, for the year the offset occurs to roll the amount into an IRA or another eligible retirement plan.8Federal Register. Rollover Rules for Qualified Plan Loan Offset Amounts With an extension, that can stretch into October of the following year. Completing the rollover in time avoids both the income tax and the 10% penalty.
Miss the rollover window and the full balance is taxed as ordinary income, with the 10% penalty on top if you are under 59½.
The Military Service Exception
If you are called to active military duty, federal law provides relief from the standard repayment schedule. Under the Uniformed Services Employment and Reemployment Rights Act, your plan can suspend loan repayments for the duration of your service.9Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA When you return, you resume payments at the same frequency and at least the same amount as before, and you must repay the full loan, including interest that accrued during the suspension, by the end of the original loan term plus the length of your military service.
Interest that accrues during service is capped at 6% per year, but you must provide a copy of your military orders to the plan sponsor and specifically request the reduced rate.9Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA The cap does not apply automatically.
How the Taxable Amount Is Reported
When a 401(k) loan triggers a taxable event, the plan administrator issues Form 1099-R. You should receive your copy by January 31 of the year after the tax event.10Internal Revenue Service. General Instructions for Certain Information Returns (2025) Box 1 shows the gross distribution amount, and Box 7 contains a code that tells the IRS what happened:11Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498
- Code L means a deemed distribution: the loan defaulted while you were still in the plan.
- Code M means a qualified plan loan offset: the loan was in good standing but offset because you left your job or the plan terminated.12Internal Revenue Service. Plan Loan Offsets
Code M may appear alongside another distribution code, such as Code 1 for an early distribution if you’re under 59½, or Code 7 for a normal distribution. Administrators should not use Code L for plan loan offsets.
If you owe the 10% early-distribution penalty, you report it on Form 5329 and include it with your Form 1040.13Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions A default or offset can also push your total income high enough to expose you to an underpayment penalty if withholding and estimated payments fall short.14Internal Revenue Service. Instructions for Form 2210 (2025) Making an estimated tax payment soon after a default can help avoid that additional charge.
State income tax generally applies too. State rates currently range from 0% to over 13%, and several states have no income tax at all. Some states partially exempt retirement distributions based on age or income. Because the rules vary widely, check your state’s tax authority for the additional liability a defaulted 401(k) loan may create.
What About “Double Taxation” of the Repayments?
A frequent worry is that repaying a 401(k) loan means paying tax twice on the same money. For the principal, this is largely a myth. You borrowed pre-tax money and repay with after-tax dollars, but you’ll only be taxed once on those dollars, when you withdraw them in retirement. The interest portion genuinely is taxed twice: you pay it with after-tax income, it lands in your pre-tax account, and you pay income tax on it again when you take retirement distributions. For most borrowers this extra cost is modest, but it’s worth weighing against other borrowing options before you take the loan.