A loan from your 401(k) is not taxed as long as it meets the requirements in Internal Revenue Code Section 72(p): the amount stays within the statutory limits, the written loan terms require full repayment within five years, payments are substantially level and made at least quarterly, and the interest rate is reasonable. Miss any one of those, and the 401(k) loan tax rules flip against you: the outstanding balance becomes a “deemed distribution,” taxed as ordinary income for the year, plus a 10% early withdrawal penalty if you’re under 59½.1IRC §72(p)
The rules below apply to 401(k)s, 403(b)s, profit-sharing plans, and governmental 457(b) plans. They do not apply to IRAs. Borrowing from a traditional or Roth IRA is a prohibited transaction and can blow up the account’s tax-advantaged status entirely, so nothing in this article is a workaround for IRA money.
How Much You Can Borrow Tax-Free
The maximum loan is the lesser of two numbers. First, $50,000. Second, the greater of half your vested account balance or $10,000. The $10,000 floor helps smaller accounts: with a $16,000 vested balance, half is $8,000, but you can still borrow up to $10,000.
The $50,000 cap is not static. It’s reduced by the difference between your highest outstanding loan balance during the 12 months before the new loan and your loan balance on the day you borrow. This blocks a pay-down-and-re-borrow cycle. If your highest balance in the past year was $40,000 and your current balance is $15,000, the reduction is $25,000, and your available limit drops from $50,000 to $25,000.
One more wrinkle: if you participate in multiple plans run by the same employer, or by employers in a controlled group or affiliated service group, all outstanding balances get added together against the $50,000 ceiling. You can’t take $50,000 from the 401(k) and another $50,000 from a sister plan.
Repayment Terms the Loan Must Meet
Staying within the dollar limit is only step one. The loan document itself has to be written correctly, and the payment pattern has to hold up over the life of the loan.
Five-Year Repayment
The loan agreement must require full repayment within five years of the origination date. This is a term written into the paperwork, not a target. A six-year loan fails on day one, even if you plan to pay it off in four.
Substantially Level Payments, At Least Quarterly
Payments have to be substantially level over the life of the loan and made no less frequently than quarterly. Payroll deduction each pay period clears this easily. What doesn’t work: balloon payments, interest-only stretches, or skipped months. Each installment has to include principal and interest.
A Reasonable Interest Rate
The rate has to be reasonable, meaning no more favorable than what a commercial lender would offer. Most plans set the rate at prime plus one or two points. Since the interest flows back into your own account, the rate is more of a compliance issue than an out-of-pocket cost.
No Credit Card or Revolving Structures
Section 72(p)(2)(D) bars loans made through credit cards or similar revolving arrangements. The loan has to be a discrete, fixed-amount transaction with a defined schedule. An open line of credit against your balance doesn’t qualify.2IRC §72(p)(2)(D)
Buying a Home: The Longer-Term Exception
The five-year rule has one exception. If the loan is used to acquire a principal residence, the plan can set a repayment term well beyond five years. Many plans allow 10, 15, or even 30 years, depending on the plan document. Level amortization and the quarterly-payment minimum still apply for the full extended term, and the dollar limits don’t change.
This exception is narrow. It covers acquisition of a principal residence, not home improvements, not refinancing, and not a vacation property. Plan administrators usually ask for documentation showing the funds are going toward a qualifying purchase.
When You Can Legally Pause Payments
Two situations let you stop making payments without triggering a taxable event.
Leave of Absence
If you take a bona fide leave of absence, either unpaid or paid too little to cover the installment, the level amortization requirement is suspended for up to one year. Interest keeps accruing. When you come back, or when the year ends (whichever is first), payments resume at whatever amount is needed to finish paying off the loan by the original deadline. The five-year clock keeps running, so expect larger payments or a lump-sum catch-up.
Military Service
Active-duty military service gets broader relief. Payments can be suspended for the full period of service, even beyond a year. When the service member returns, the five-year deadline is extended by the length of the military service. Borrow in January 2024, serve on active duty for 18 months, and the repayment deadline moves from January 2029 to roughly mid-2030.
Missing a Payment: The Cure Period
Plans aren’t required to give you a grace period, but many do. The maximum cure period allowed by regulation is the end of the calendar quarter following the quarter in which the missed payment was due. Miss a February 15 payment, and the outer edge of the cure period is June 30.
Catch up inside the cure period and the loan stays in good standing. Miss it, and the entire outstanding balance plus accrued interest becomes a deemed distribution on the last day of the cure period. Some plans set a shorter cure window, and some offer none at all. Check your plan document before assuming you have time.
What a Failed Loan Costs You
When a loan blows any of the Section 72(p) requirements, the outstanding balance is treated as a deemed distribution. The full amount, principal plus accrued interest, is added to your gross income for the year of the failure and taxed at your ordinary income rate. The plan administrator reports it on Form 1099-R.
If you’re under 59½ when the deemed distribution hits, the 10% early withdrawal penalty under Section 72(t) applies on top of regular income tax. The standard exceptions to the penalty, such as disability, can apply, but most participants in this situation don’t qualify for one.
You Can’t Roll It Over
This is the part that catches people. A deemed distribution is not eligible for rollover. Unlike an actual cash distribution, where you’d have 60 days to move the money into an IRA and avoid tax, a deemed distribution is a tax event only. The cash never left the plan; it’s still sitting there as an outstanding loan balance. There’s nothing to roll over, and no mechanism to undo the tax bill.
The Double-Tax Problem
After a deemed distribution, you’ve already paid tax on the balance. But the plan may still require you to keep making payments, and those payments are now after-tax dollars flowing into a pre-tax account. When you eventually take a real retirement distribution, that money gets taxed again as ordinary income. The same dollars end up taxed twice. Some plans track after-tax basis to provide relief at distribution; many don’t, and the recordkeeping burden falls on you.
If You Leave Your Job With a Loan Balance
Separating from service with an outstanding balance triggers something different: a plan loan offset. The plan reduces your account balance to satisfy the loan. Unlike a deemed distribution, an offset is an actual distribution for tax purposes, which means it can be rolled over.
If the offset qualifies as a “qualified plan loan offset” (QPLO), meaning it was triggered by plan termination or severance from employment, you have until your tax filing deadline for the year of the offset, including extensions, to roll the amount into an IRA or another eligible plan. For non-QPLO offsets, the standard 60-day rollover window applies.
The rollover doesn’t have to come from the plan itself. If your offset is $20,000, you can deposit $20,000 from any source into an IRA by the deadline and avoid tax on the whole amount. Roll over less than the full amount and you’ll owe tax on the portion you didn’t cover, but partial rollovers are allowed.