Quick Summary
A 401(k) plan may let participants borrow from their accounts, but loans must follow IRS limits on amount, repayment period, and payment schedule. Plans that offer loans need a written loan policy covering items such as interest rates, the number of loans allowed, and fees. Payroll errors in loan repayments are a common operational failure. Sponsors should weigh the flexibility loans provide against the risk that borrowing reduces long-term savings.
Many employees like knowing they can borrow from their 401(k) if they need to. For some, that flexibility makes them more comfortable contributing in the first place. But plan loans come with strict IRS rules, and mistakes in administering them are among the more common operational problems in small plans.
If your plan offers loans, or you are considering adding them, here is what to know.
Loans are optional
No law requires a 401(k) to offer loans. If a plan does, the plan document must permit them, and Department of Labor regulations require the loan program to be set out in writing, either in the plan document or in a separate written loan policy.
The IRS limits
To avoid being treated as a taxable distribution, a plan loan must meet several requirements.
Maximum amount. A participant can generally borrow the lesser of:
- $50,000, reduced by the participant's highest outstanding loan balance during the prior 12 months, or
- The greater of 50% of the vested account balance or $10,000
Plans are not required to use the $10,000 provision, and many simply limit loans to 50% of the vested balance.
Repayment period. Loans must be repaid within five years, except loans used to buy the participant's principal residence, which can have a longer term.
Payment schedule. Repayments must be made in substantially level installments, at least quarterly. Most plans collect repayments through payroll deduction each pay period.
Interest rate. Loans must carry a reasonable rate of interest. Many plans use the prime rate plus one or two percentage points.
Design choices for your loan policy
Beyond the IRS rules, sponsors make several decisions:
- Number of loans. Many plans allow only one or two outstanding loans at a time.
- Minimum loan amount. A minimum, such as $1,000, reduces the number of very small loans.
- Purpose. Most plans allow loans for any reason, but some limit them to specific purposes.
- Fees. Recordkeepers often charge an origination fee and sometimes an annual maintenance fee, usually paid from the borrower's account.
- Repayment after termination. Some plans allow former employees to continue repaying directly, while others require repayment in full.
- Leaves of absence. Repayments may be suspended for up to one year during an unpaid leave, with longer suspension permitted during military service.
What happens when a loan defaults
If a participant misses a payment, the plan may allow a cure period lasting until the end of the calendar quarter following the quarter in which the payment was missed. If the payment is not made by then, the outstanding balance becomes a deemed distribution. It is taxable income, and if the participant is under age 59½, a 10% additional tax may also apply.
When an employee leaves
Many plans require the loan to be repaid when employment ends. If it is not, the unpaid balance is typically offset against the account, which is treated as a distribution. Under current law, a participant who leaves employment with an outstanding loan generally has until the due date of their tax return, including extensions, to roll over the offset amount and avoid taxes.
Common mistakes
Loan administration errors tend to follow a few patterns:
- Repayments that never start because payroll was not set up
- Repayments that keep going after the loan is paid off
- Loans that exceed the dollar or percentage limits
- Loan terms longer than five years for non-residential loans
- Missing loan documentation
- Loan repayments deposited late, which are treated like late employee contributions
Many of these can be corrected through the IRS Employee Plans Compliance Resolution System, and since 2025, the Department of Labor's Voluntary Fiduciary Correction Program has offered a self-correction option for certain late repayments and loan failures. Prevention is still easier than correction, which is why payroll integration and periodic reconciliation matter.
Weighing the tradeoffs
Loans offer flexibility and can make some employees more willing to contribute. They also take money out of the market while it is borrowed, and a job change can turn an outstanding loan into a taxable distribution. Sponsors who offer loans often pair them with education about these tradeoffs and with limits that discourage frequent borrowing.
Want a second look at your plan's loan policy? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design and operations. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Where does the loan interest go?
Interest paid on a 401(k) loan goes back into the participant's own account, not to the employer or the recordkeeper.
Can a plan stop offering loans?
Yes. The plan can be amended to stop offering new loans. Existing loans generally continue under their original terms.
Do loan repayments have to be deposited on the same timeline as contributions?
Yes. Loan repayments withheld from pay are subject to the same timely deposit rules as employee contributions.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.