When you roll over a 401(k) with an outstanding loan, the plan administrator subtracts what you still owe from your account balance before moving anything to your new IRA or employer plan. Only the reduced amount actually transfers. The IRS treats the subtracted piece as a distribution to you, so it becomes taxable income for that year, and if you’re under 59½, a 10% early withdrawal penalty stacks on top. You can undo both hits by depositing an equal amount of personal money into the receiving account by your tax filing deadline, but the mechanics and timing catch people off guard.
How the Offset Reduces Your Rollover
The reduction is called a plan loan offset. If your account holds $50,000 and you owe $10,000 on the loan, only $40,000 rolls to your new account. The $10,000 doesn’t disappear; the IRS treats it as an actual distribution even though no check ever reached you.1Internal Revenue Service. Plan Loan Offsets
The plan reports the offset on Form 1099-R, the same form used for any retirement distribution. When it meets the criteria for a qualified plan loan offset, box 7 carries distribution code M.2Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025) Because the offset is treated as an actual distribution rather than a deemed one, it remains eligible for rollover.3Internal Revenue Service. Retirement Plans FAQs Regarding Loans That eligibility is the door the tax code leaves open for you.
The Tax Bill on the Unpaid Balance
The offset counts as ordinary income in the year it happens. You report it from the 1099-R on your Form 1040, and the rate depends on your total taxable income for the year.1Internal Revenue Service. Plan Loan Offsets A five-figure offset can push you into a higher bracket if you’re already near a threshold.
If you’re under 59½ at the time of the offset, add a 10% early distribution penalty on the same amount.4Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts On a $10,000 offset, that’s a $1,000 penalty before federal or state income tax enters the picture. If you haven’t adjusted withholding or made an estimated payment to cover the surprise income, the IRS failure-to-pay penalty can accrue at 0.5% of the unpaid tax per month, up to 25%.5Internal Revenue Service. Failure to Pay Penalty
The Deadline to Replace the Money and Avoid the Tax
The Tax Cuts and Jobs Act extended the rollover deadline for a specific category of offset called a qualified plan loan offset (QPLO). Instead of the older 60-day window, you have until the due date of your federal income tax return for the year of the offset, including extensions, to deposit an equal amount into an IRA or your new employer’s plan.6Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
Two conditions define a QPLO: the loan was in good standing at the time of the offset, and the offset happened because either the plan terminated or you separated from your employer.2Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025) If you had already defaulted on payments before leaving, it doesn’t qualify, and the 60-day rule applies.
In practice, if you leave your job in June 2026 and the plan offsets a $15,000 loan, you have until April 15, 2027 to deposit $15,000 of your own money into an IRA or your new employer’s 401(k). Filing Form 4868 for an automatic extension moves the deadline to October 15, 2027.7Internal Revenue Service. About Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return Making that deposit converts the taxable distribution into a tax-free rollover and wipes out both the income tax and the 10% penalty. The receiving institution reports the deposit on Form 5498 as a rollover contribution.8Internal Revenue Service. Form 5498 IRA Contribution Information
Partial Replacement Still Helps
The rollover isn’t all-or-nothing. If your QPLO was $15,000 and you can only pull together $9,000 by the deadline, roll over the $9,000 and pay tax on the remaining $6,000. Every dollar you replace is a dollar that escapes taxation.9Internal Revenue Service. Topic No. 413, Rollovers From Retirement Plans For someone in the 22% bracket and under 59½, a $6,000 gap runs about $1,920 in combined tax and penalty, and each additional $1,000 rolled over knocks roughly $320 off the bill.
Cleaner Options Before the Offset Happens
Your loan doesn’t convert to a distribution the moment you clean out your desk. Plan sponsors set their own timing, and rules vary. Some plans demand full repayment at separation. Others allow a cure period, commonly around 30 days, during which you can repay the balance in full and prevent the offset entirely.10Internal Revenue Service. Retirement Topics – Plan Loans The plan’s summary plan description spells out the exact deadline, and it’s worth reading before you give notice.
Paying the loan off before the plan processes any distribution is the simplest path. A $15,000 payoff from savings costs you $15,000. That same $15,000 as an unreplaced offset costs someone in the 24% bracket and under 59½ about $5,100 in combined tax and penalty, and the retirement savings are gone permanently.
Transferring the Loan to the New Plan
A less common option is moving the loan itself, meaning the promissory note and repayment obligation, into your new employer’s plan. If the new plan accepts it, you continue payments through payroll deduction and no offset occurs. No federal law requires an employer to take an incoming loan, and most plans don’t. If you’re weighing a job offer with a large loan balance outstanding, ask the new employer’s HR department whether their plan accepts loan rollovers before you commit to a start date.
The Withholding Trap When Cash Is Also Distributed
If your distribution includes both the loan offset and a cash payout, the 20% mandatory withholding rule creates a math problem most people miss. Withholding applies to the entire eligible rollover distribution, but it can only come out of the cash side, since no actual money changes hands on the offset.1Internal Revenue Service. Plan Loan Offsets
Say the total distribution is $10,000: a $3,000 offset and $7,000 in cash. The plan must withhold 20% of $10,000, or $2,000, and the entire $2,000 comes out of the cash. You actually receive $5,000. To roll over the full $10,000 and avoid all tax, you’d need to replace both the $3,000 offset and the $2,000 withheld, so $5,000 from your own pocket. You get the $2,000 back as a credit at tax time, but the cash flow squeeze hits now.
When the offset is the only distribution and no cash is paid out, no withholding applies.1Internal Revenue Service. Plan Loan Offsets Electing a direct rollover for the cash portion to your new plan or IRA also avoids the 20% withholding on that cash, because withholding only applies to amounts paid to you rather than rolled directly.
Protections for Active-Duty Service Members
Deployment or activation doesn’t have to trigger a loan default or offset. Retirement plans can allow a suspension of loan repayments while a participant is performing military service under USERRA. When the service member returns, payments resume at the same frequency and amount, and the maximum loan term is extended by the length of the service period.11Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA
Interest accruing during the service period is capped at 6%. To get that rate, the service member must give a copy of military orders to the plan sponsor and specifically request the reduction.11Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA The Servicemembers Civil Relief Act separately caps interest at 6% on most pre-service debts, which can include plan loans taken out before entering active duty.12U.S. Department of Justice. Your Rights as a Servicemember: 6% Interest Rate Cap for Servicemembers on Pre-Service Debts The plan must permit suspension for these protections to apply, so confirm the details with the administrator before deployment.