IRC 72(p): Plan Loan Limits, Repayment, and Deemed Distributions

A 401(k) loan generally is not taxed when you take it, but the tax rules for a 401(k) loan give you only a narrow set of conditions to keep it that way: borrow within the federal dollar limits, repay on the schedule the law requires, and settle the balance correctly if you leave your employer. Miss any of those and the IRS treats the outstanding amount as a distribution, adding it to your income for the year and, in most cases under age 59½, tacking on a 10% early withdrawal penalty.

How Much You Can Borrow Tax-Free

Federal law caps the loan at the lesser of $50,000 or the greater of $10,000 or half your vested account balance.¹ For most participants with meaningful balances, that means half your vested balance up to $50,000. The $10,000 floor helps people with smaller accounts: if your vested balance is $15,000, you can still borrow $10,000 even though half your balance is only $7,500.²

The $50,000 ceiling has a wrinkle that catches repeat borrowers. If you had a loan from the same plan in the prior 12 months, your new maximum is reduced by the difference between the highest outstanding balance during that period and the current balance on the day the new loan is issued.¹ Say you borrowed $40,000 a year ago and paid it down to $25,000. Your new cap is not $50,000 minus $25,000. It is $50,000 minus ($40,000 minus $25,000), which leaves a combined ceiling of $35,000. The rule is there to stop people from cycling through large loans back to back.

Some plans permit more than one outstanding loan, but each loan has to independently satisfy the repayment rules and the combined balances still cannot exceed the dollar cap.³ Many plans limit you to one or two loans regardless of what the IRS would allow.

Repayment Rules That Keep the Loan Tax-Free

The loan must be fully repaid within five years of the date the money leaves your account.² There is no flexibility on that deadline for a general-purpose loan. One day past the five-year mark and the remaining balance becomes taxable.

Payments have to follow what the IRS calls substantially level amortization: roughly equal installments of principal and interest made at least quarterly.² You cannot back-load the loan with tiny payments and a balloon at the end. Most plans deduct payments directly from your paycheck, which keeps you in compliance almost automatically while you are still employed.

The loan also needs a written agreement stating the amount, schedule, and interest rate. Plans typically set the rate at prime plus one percentage point. The rate must be commercially reasonable, meaning it should look like what a bank would charge on a similar unsecured loan. A zero-interest or token-rate loan looks less like a real debt and more like a disguised withdrawal, which is how the IRS will treat it.

When a Loan Becomes a Taxable Distribution

The IRS calls this a deemed distribution. The outstanding balance is treated as though the plan paid it out to you, even though no money moved. The usual triggers are missing a scheduled payment and not curing it in time, borrowing more than the statutory limit, or letting the term run past five years.

Miss a payment and you get a short grace period. The plan can wait to declare the deemed distribution until the end of the calendar quarter that follows the quarter in which the payment was due.¹ A payment due May 15 gives you until September 30 to catch up. Miss that window and the full outstanding principal is treated as distributed on the last day of the cure period.

A detail people miss: the deemed distribution does not erase the loan. You still owe the plan, interest keeps accruing, and the balance stays on the books until an actual distribution event, such as leaving your job, triggers a loan offset. You can even continue paying after a deemed distribution, and those later payments build tax basis in the account, which reduces the tax hit on future real withdrawals.¹

The Tax Bill If Your Loan Defaults

The full amount treated as distributed gets added to your gross income for the year and taxed at your ordinary rate. If your state has an income tax, you owe that as well. Because the amount lands on top of your regular earnings, it can push you into a higher bracket for the year.

If you are under 59½, you generally owe an additional 10% early withdrawal penalty. A 40-year-old whose $30,000 loan defaults would owe income tax on $30,000 plus a $3,000 penalty. The penalty does not apply if you fit a statutory exception such as separation from service after age 55, disability, or a qualified domestic relations order.²

A deemed distribution cannot be rolled into an IRA or another plan to defer the tax.¹ That is one of the important differences from a loan offset, where a rollover can rescue you.

Your plan reports the amount on Form 1099-R. Box 7 shows Code L, telling the IRS this is a loan treated as a distribution.⁴

Leaving Your Job With an Outstanding Balance

This is where most people get caught. When you separate, payroll deductions stop and the automatic repayment mechanism ends. Some plans let you keep paying directly; many require immediate repayment. If you cannot pay, the plan reduces your account balance by the outstanding loan amount. That reduction is called a loan offset, and unlike a deemed distribution it is treated as an actual distribution.⁵

The key difference: a loan offset can be rolled over to avoid immediate tax. The deadline depends on the offset type.

Standard loan offset: 60 days from the date of the distribution to roll the amount into an eligible retirement plan.
Qualified Plan Loan Offset (QPLO): if the offset happened because you left your job or the plan was terminated, and the loan was in good standing when it happened, you have until your tax filing due date for that year, including extensions, to complete the rollover.⁶

The QPLO window is a real lifeline. Leave your job in March 2026 with a $20,000 loan that gets offset and you have until April 15, 2027, or October 15, 2027 with an extension, to deposit $20,000 into an IRA.⁵ You do have to come up with the cash from other sources, since your account balance already paid the debt, but the tax saved on a five-figure offset is often worth the effort.

If you previously took a deemed distribution on the same loan and later separate from service, the offset amount on the 1099-R generally is not taxed a second time. Your basis was already adjusted when you paid tax the first time. Keep the records from both events.

The Hidden Double Tax on Loan Interest

There is a quieter tax cost that applies to every 401(k) loan, even one you repay on schedule. Loan payments run through payroll and come out of after-tax pay. The principal portion swaps pre-tax dollars for after-tax dollars, which mostly nets out. The interest portion is new money going into the account. You earned it, paid tax on it, sent it into the 401(k) as interest, and you will pay income tax on it again when you withdraw it in retirement.

On a $20,000 loan at 9% over five years, the interest runs roughly $4,900. In a combined 30% bracket now and later, that pattern costs about $1,470 in extra lifetime tax. Not catastrophic on its own, but it adds up across multiple loans over a career, and it rarely shows up in the plan’s disclosures.

The Home Purchase Exception

The five-year clock does not apply to a loan used to buy your primary residence. Plans can extend the term to something closer to a standard mortgage, such as 15 or 30 years.² The exception covers acquisition only, not refinancing, renovations, or paying down an existing mortgage.

Every other rule still applies. The dollar cap is the same. Level amortization and at least quarterly payments are still required. And if you leave your employer before the loan is paid off, the offset and rollover rules kick in exactly as they would for a five-year loan. A 20-year home loan becomes a real problem if you change jobs five years in.

Military Service Protections

If you are called to active duty, the plan can suspend loan repayments for the entire period of service, and federal law treats that suspension as compliant with the repayment and amortization rules.⁷ When you return, the loan is re-amortized over what remains of the original term plus the length of the suspension, and the overall term can run past five years by that same amount of time.⁸

Separately, the Servicemembers Civil Relief Act caps interest at 6% per year on loans that existed before you entered service, including fees and service charges. You must give the plan written notice and a copy of your orders within 180 days after release. Anything charged above 6% during the service period must be forgiven.⁹

Does Your Spouse Have to Consent

Most standalone 401(k) plans do not require spousal consent for a loan. The consent requirement applies to plans subject to qualified joint and survivor annuity rules, which mainly means traditional pension plans and some older profit-sharing plans. A 401(k) is generally exempt as long as the spouse is the default beneficiary, the plan does not offer a participant-elected life annuity, and the account does not hold transferred assets from a plan that was subject to those annuity rules.¹⁰ Where consent is required, missing it can disqualify the loan from day one, which turns the whole balance into a taxable distribution immediately. Check your plan document before assuming you don’t need a signature.

1
Internal Revenue Service. Retirement Plans FAQs Regarding Loans
2
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. Borrowing Limits for Participants With Multiple Plan Loans
4
Internal Revenue Service. Instructions for Forms 1099-R and 5498
5
Internal Revenue Service. Plan Loan Offsets
6
Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
7
Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
8
Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA
9
CCH Incorporated. May 401(k) Loans Be Suspended When an Employee Is on Military Leave
10
Internal Revenue Service. Issue Snapshot – Spousal Consent Period to Use an Accrued Benefit as Security for Loans