The IRS loan rules for retirement plans and family loans come down to two separate traps. A loan from your 401(k) or similar workplace plan stays tax-free only if it meets every requirement in Internal Revenue Code Section 72(p); miss one and the balance is treated as a taxable distribution. A loan to a relative at little or no interest triggers Section 7872, which imputes interest the IRS treats as paid and received even when no cash moves. Both can produce tax bills on money you never saw.
How Much You Can Borrow From a 401(k) and for How Long
A loan from a qualified employer plan is not taxed as a distribution as long as it meets the Section 72(p) rules. The borrowing cap is the lesser of $50,000 or half your vested account balance. There is a floor: if half your vested balance is less than $10,000, you can still borrow up to $10,000, but never more than the vested balance itself.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The $50,000 ceiling also shrinks if you had another plan loan in the prior 12 months. It is reduced by the difference between your highest outstanding balance during that lookback period and the balance on the day the new loan is made, which prevents repeatedly cycling loans at the maximum.
Repayment must happen within five years through substantially level payments made at least quarterly. A longer term is allowed when the loan is used to buy your principal residence; the IRS sets no maximum there, and the plan document controls.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The interest rate must be commercially reasonable. Most plan administrators use prime plus one percentage point, which the IRS has consistently accepted. The loan must be documented with a legally enforceable promissory note identifying the schedule, rate, and the portion of your vested balance pledged as collateral. The interest you pay flows back into your own account, but for most participants borrowing against elective deferrals, that interest is not tax-deductible.
When a Plan Loan Becomes a Taxable Distribution
Miss a payment, exceed the borrowing limit, or break the level-amortization requirement and the IRS treats the loan as a deemed distribution. The outstanding principal plus accrued interest becomes taxable income in the year the failure occurs.2Internal Revenue Service. Deemed Distributions – Participant Loans
Your plan administrator will issue Form 1099-R to you and the IRS. You report that amount as ordinary income on Form 1040. If you are under age 59½, you also owe a 10% early withdrawal penalty unless you qualify for one of the narrow statutory exceptions.
Deemed distributions are especially painful because no actual cash leaves the plan. The administrator typically has nothing to withhold from, so you receive a tax bill for the full amount without receiving any money, and the plan still expects you to keep repaying the loan. The obligation does not disappear just because the IRS taxed you on the balance.3Internal Revenue Service. Fixing Common Plan Mistakes – Plan Loan Failures and Deemed Distributions
Leaving a Job With an Outstanding Plan Loan
Job separation is the most common trigger for plan loan problems. Many plans require immediate repayment when you leave, and if you cannot pay, the plan reduces your account by the loan amount. This is a plan loan offset, treated as an actual distribution rather than a deemed one.4Internal Revenue Service. Plan Loan Offsets
The distinction matters because of the rollover deadline. A qualified plan loan offset, which happens specifically because of job separation or plan termination, gives you until your tax filing due date for that year, including extensions, to roll the offset amount into an IRA or another eligible plan. That effectively means October 15 of the following year if you file an extension. You do not need cash from the old plan; you can contribute an equivalent amount of your own money to the IRA and report the rollover on your return. Miss that deadline and the full offset becomes taxable, plus the 10% penalty if you are under 59½.
Fixing a Plan Loan Mistake Before It Costs You
Not every loan failure has to end in a tax hit. The IRS offers correction programs through the Employee Plans Compliance Resolution System that can remove the deemed distribution entirely if the error is caught and fixed properly.
For operational mistakes, like a loan that accidentally exceeded the dollar limit or a missed quarterly payment, the plan sponsor can self-correct without filing anything or paying a fee, provided the sponsor had reasonable compliance procedures and the failure was an isolated oversight.5Internal Revenue Service. Retirement Plan Errors Eligible for Self-Correction More serious failures require the Voluntary Correction Program, filed on Form 8950 with a user fee. A successful correction removes the Form 1099-R reporting and wipes out the deemed distribution, so it is worth pressing your plan administrator to pursue correction rather than accepting the tax bill.3Internal Revenue Service. Fixing Common Plan Mistakes – Plan Loan Failures and Deemed Distributions
The Minimum Interest Rate for Family Loans
When you lend to a family member below the IRS minimum rate, Section 7872 imputes the missing interest. The IRS pretends the lender gave the borrower enough money to cover market-rate interest, then pretends the borrower paid that interest back. Both fictional transfers have tax consequences: the lender reports interest income, and the “gift” leg can also carry gift tax reporting.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
The minimum rate is the Applicable Federal Rate, published monthly by the IRS. The correct AFR depends on the loan’s term:
- Short-term (3 years or less): 3.59% annually as of March 2026
- Mid-term (over 3 years through 9 years): 3.93% annually
- Long-term (over 9 years): 4.72% annually
These rates change monthly. For a term loan with a fixed repayment date, the rate that governs is the one in effect the month the loan is made, and it locks in for the life of the loan. For a demand loan, which the lender can call due at any time, the imputed interest is recalculated each year using the short-term AFR then in effect. Charging even a fraction below the correct AFR triggers imputed interest on the entire shortfall.
The Exceptions That Protect Most Family Loans
Section 7872 contains two exceptions that keep ordinary family loans out of trouble.
The $10,000 De Minimis Exception
If the total outstanding loans between two individuals never exceed $10,000, the imputed interest rules do not apply at all. This covers the typical informal loan between relatives. The exception vanishes if the borrower uses the money to buy income-producing assets like stocks or rental property.
The $100,000 Net Investment Income Cap
For gift loans where the balance stays at or below $100,000, the imputed interest the lender must report is capped at the borrower’s net investment income for the year. If the borrower earned less than $1,000 in net investment income (interest, dividends, and capital gains combined), the IRS treats the figure as zero, meaning no imputed interest at all.
A parent who lends a child $80,000 interest-free to help with a house down payment owes nothing in imputed interest income as long as the child’s net investment income stays under $1,000. Once the aggregate balance crosses $100,000, this cap disappears and the full rules apply. The exception also does not apply if tax avoidance is a principal purpose of the loan.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
When Imputed Interest Triggers Gift Tax Reporting
When the imputed interest on a gift loan exceeds the annual gift tax exclusion ($19,000 per recipient for 2026), the lender must file Form 709. Imputed interest counts alongside any other gifts to the same person during the year. Exceeding the exclusion does not necessarily mean owing gift tax; it reduces the lender’s lifetime exemption and triggers the reporting requirement.8Internal Revenue Service. What’s New — Estate and Gift Tax
Document the Loan or Lose the Argument
The single most important thing you can do with a family loan is put it in writing. A formal promissory note specifying principal, interest rate, maturity date, and repayment schedule is what separates a loan from a gift in the IRS’s eyes. Without documentation, the IRS can recharacterize the entire principal as a taxable gift on the date it was transferred.
Keep a consistent payment history too. Sporadic or nonexistent payments signal that neither party intended repayment, which is the argument the IRS will make in an audit. Even if the loan falls within the $10,000 or $100,000 exceptions, documentation protects you if the arrangement is questioned.
On reporting: a lender with imputed interest income reports it on Schedule B. If imputed interest plus other gifts to the same borrower exceeds the annual exclusion, add Form 709.9Internal Revenue Service. Topic No. 403, Interest Received