Quick takeaways
401(k) loans involve an eligible participant borrowing funds from their 401(k).
Not all plans allow 401(k) loans; it's up to each plan sponsor to decide.
401(k) loan provisions are highly customizable so it is important to look at the details for each plan.
401(k) loans are governed by many rules and regulations, so it's important as a plan sponsor to get expert advice from a financial professional to make sure you set up a plan that works for you.¹
As a 401(k) plan sponsor, you're likely facing a lot of important decisions. One of those key decisions is whether or not to offer 401(k) loans. Not all plans offer loans, because not all plan sponsors choose to do so and not all service providers allow them.
It's important to consider the benefits and challenges of offering 401(k) loans when deciding if you will offer them. Some plan sponsors may wish to offer loans because their participants like the flexibility they can offer, especially younger employees who may be wary of having money "locked up" in a retirement account.
Other plan sponsors refrain from offering loans because of the recordkeeping complexities and because they may put participants at risk of defaulting and damaging their retirement savings. Ultimately, it's important to understand 401(k) loans in-depth so you can make an informed decision that is right for your company.
What is a 401(k) loan?
A 401(k) loan is a loan in which an eligible participant borrows against the funds in their 401(k). The IRS and the Department of Labor both have 401(k) loan rules that plan sponsors and participants have to follow.
A 401(k) loan typically has a relatively low interest rate compared to unsecured personal loans, and borrowers generally have up to five years to repay it. However, as an employer, you can set additional rules or requirements. Also, some employers may choose to not allow 401(k) loans at all. Please keep in mind that we will discuss the outside parameters of a 401(k) loan program, but the plan sponsor or service provider may decide to put in stricter requirements.
How does a 401(k) loan work?
A 401(k) loan works differently from other loans because the borrower isn't borrowing money from a lender. Instead, the borrower borrows from their own 401(k) balance with remaining 401(k) assets acting as security. This allows a participant to gain access to the funds without the burden of an early withdrawal penalty, provided all loan rules are followed.1 Then the borrower will repay the money to their account with interest.
After a participant requests a loan and it is approved, some of their investments will be sold, and they'll receive the cash. They then have to repay the loan based on the loan agreement. At minimum, the loan agreement will include how payment will be made (typically through payroll deductions), how long payments are made for, how often the payments are made, the interest rate used, and the repayment (also known as amortization) schedule. They must repay the loan within five years (unless they use the money to purchase a primary residence).
If a participant falls behind on their loan payments, the loan could be considered a taxable distribution. In that case, they may have to pay income taxes and an early withdrawal penalty unless a penalty exception applies.3
What if your employee quits or gets let go? It's important for them to know that their repayment schedule could be accelerated in this case. They may be able to make a lump sum repayment, or if both plans allow, they can roll over their loan balance to another eligible retirement plan. If they are unable to do either and the loan is offset, the participant may be able to rollover the unpaid loan amount by funding it out of pocket into a new eligible retirement account.4
Types of 401(k) loans
There are two major categories of 401(k) loans:
401(k) general purpose loans
For a 401(k) general-purpose loan, participants can typically use the money they borrow for whatever they like. That's why it is considered "general-purpose." While the plan's loan policy can limit the reasons for taking a loan (e.g. only if the participant meets the requirements to take a safe harbor hardship distribution) care must be taken to confirm that loans are available to all participants on an equivalent basis. Generally, the application process doesn't require the participant to specify the reason for the loan or their plans for the money. The maximum repayment period for a general-purpose loan is five years but the plan can require a shorter repayment timeframe.
401(k) residential loans
On the other hand, with a 401(k) residential loan, borrowers can only use the money to purchase a primary residence. For this kind of loan, participants must submit supporting documents, such as a purchase and sales agreement. Residential loans often provide longer repayment terms compared to general-purpose loans but must be limited to what a reasonable mortgage length would be.
What's the difference between a 401(k) loan and hardship withdrawal?
A hardship withdrawal is a one-time withdrawal of funds that a participant may be able to take if they experience extreme financial hardship. Of course, the IRS has some specific rules for what that hardship looks like and what the money can be used for. In general, these qualified expenses include certain medical expenses, principal residence purchase (excluding mortgage), tuition-related costs, payments to prevent eviction, burial or funeral expenses, casualty deduction costs for primary residence, and certain emergency repairs to primary residence. With a hardship withdrawal, the money cannot be paid back or rolled over to an IRA or other retirement plan. With a hardship withdrawal, the pre-tax amount is included as taxable income in the year of the distribution and it will be subject to the 10% early withdrawal penalty tax unless an exception applies.
A 401(k) loan is different because it is a loan; it must be repaid. Additionally, participants can generally use a 401(k) loan for whatever they please, not just specific expenses.
401(k) loan guidelines for employers
As a plan sponsor, here are some important guidelines you should know about 401(k) loans1:
Understand 401(k) loan limits
Both the IRS and the Department of Labor have rules around how much participants can borrow with a 401(k) loan. The IRS allows eligible participants to borrow up to 50% of their vested 401(k) retirement savings, with a $50,000 cap2. The Department of Labor also limits the maximum amount that a participant can borrow. Taking into account both sets of rules, the formula for determining the maximum loan one can take is the lesser of:
50% of your vested account balance; OR
$50,000 minus the highest outstanding balance in the past 12 months
As a plan sponsor, you will also be called upon to set some limits for the 401(k) loans you offer. These include interest rate, acceptable repayment schedule, maximum loan terms, and more. While your loan policy can be changed at any time, those changes would not apply to existing loans. So it's important to figure out what will work best for your organization up front, to hopefully avoid any big changes down the line.
Set an interest rate
As the plan sponsor, it's up to you to decide the interest rate for your 401(k) loan offering. The IRS does mandate that 401(k) loans must be secured and the interest rate and repayment schedule you choose must be "commercially reasonable." So you can't offer something that is worse or better than a rate your participant could get from another lender on the market for the same type of loan. Most plan sponsors will tie their rate to the Wall Street Journal's Prime Rate.
Create a repayment schedule
Just like setting an interest rate, you must set reasonable repayment requirements. For general-purpose 401(k) loans, the maximum amount of time for repayment is five years (though it can be longer for principal residential loans). Your participants must make equal repayments, so no balloon payments or payments that increase over time. Repayments must include both interest and principal payments each time, and they have to be made at least quarterly.
Provide proper documentation
As you probably know by now, as a plan sponsor there is a lot of reporting, paperwork, and documentation to keep track of. When it comes to 401(k) loans, there are a few important pieces of info you must keep track of and report accurately for each loan. These include:
Terms of the loan, including amount
Loan interest rate
Total interest
First loan repayment date
Length of the loan
Loan repayment frequency
Term agreement
Amortization schedule
What happens when a plan loan goes wrong?
Deemed distribution
Not every loan problem is treated the same way and the difference matters for both the participant and the plan sponsor.
A deemed distribution happens when a loan fails to meet the regulatory requirements (e.g., missed payments, too much taken, loan not repaid by the end of the time frame) and the remaining outstanding balance will be treated as a withdrawal. When a deemed distribution occurs, the remaining outstanding balance will be treated as ordinary income and is subject to the 10% early withdrawal penalty unless an exception applies.
Critically, a deemed distribution doesn't erase the debt; the loan stays on the books, continues to accrue interest, and the participant must still repay it, even though they've now been taxed on it. If the plan only allows for a single outstanding loan, the participant will not be able to take another loan until the deemed one has been repaid or offset. The plan reports the deemed distribution to the IRS on Form 1099-R for the year it occurs. The amount deemed distributed cannot be rolled over to any other retirement plan or IRA.
Loan offset
A loan offset is different. It happens when the plan actually reduces the participant's account balance to satisfy the outstanding loan. An offset can only occur when the participant is otherwise eligible to take a distribution (e.g., upon leaving service,). Unlike a deemed distribution, a loan offset resolves the debt; the participant's obligation to repay ends because the plan used their own account balance to pay it off.
The offset amount is included in income, but unlike a deemed distribution, the amount is eligible to be rolled over to an eligible retirement plan or IRA. In general, a loan offset can be rolled over within 60 days of the offset. However, if the offset is due to the plan terminating or leaving employment and it happens within 12 months of the termination date, the participant will have until their tax return due date (plus extensions) for the year of distribution to complete the rollover (find more information here).
Both deemed distributions and loan offsets can often be avoided with careful plan administration, and even after the fact, plan sponsors have options for correcting loan failures, which we cover next.
Common pitfalls of 401(k) loans and how to fix them
While there are many employers who choose to offer 401(k) loans, they do have some pitfalls that can cause you headaches if you don't stay on top of them. In general, the IRS and DOL provide guidelines on fixing the issues. Below we will point out the most common failures and corrections methods but depending on the issue and the service provider other options may be available.
Loans exceeding the maximum amount
Participants cannot take out a loan that exceeds the maximum dollar amount they are allowed. If you, as a plan sponsor, approve a loan that is too much, your participant could end up in a tight spot.
What's the fix? The borrower can make a lump sum repayment of the amount over the limit or the excess amount will become a deemed distribution.
Loans with payment schedules that don't meet time limits
Participants cannot take longer than five years to repay a general purpose 401(k) loan.
What's the fix? The borrower can make a lump sum repayment of the amount still left up until the last day of the loan term and any amount remaining unpaid past the deadline will become a deemed distribution.
Defaulted loans
Participants must stay current on their loan payments.
What's the fix? The borrower can catch up on missed payments by the end of the "cure period," a sort of grace period during which payments can still be made, if permitted by the terms of the loan. If it is beyond the cure period, then the remaining unpaid balance would become a deemed distribution.
Employee leaves the organization
When an employee no longer works for you, the loan policy can require that they repay the balance on any outstanding 401(k) loan.
What's the fix? The borrower can make a lump sum repayment or if both plans allow they can roll over their loan to an eligible retirement plan. If they are unable to do either and the loan is offset (discussed later) and the participant can rollover the amount of the unpaid loan balance to a new retirement plan, however, they must fund it out of pocket.
How to correct issues with 401(k) loans
The allowable correction method will depend on the type of issue and what you as the plan sponsor allow. Per the IRS, "If participant loans under your plan do not meet the legal requirements, or if repayments have not been made according to the schedule set out in the loan document, you may be able to correct these problems using the Voluntary Correction Program. So luckily, there are remedies if issues happen with 401(k) loans your organization offers.
Why should I offer 401(k) loans?
Some employees may not want to enroll in a retirement plan and set aside money if they think they can't easily access it in case of an emergency or life-changing event. By allowing loans, employees can feel more confident that they'll be able to use the funds if they need to.
If you choose to offer 401(k) loans, here are a few best practices you may want to think about3:
Provide education on your plan offerings, including the ins and outs of 401(k) loans. Consider offering Q&A sessions for employees so they can get all of their questions answered.
You may not want to encourage participants to take loans. If they are looking to you for financial advice, connect them with a qualified retirement or financial advisor who can help them figure out the best course of action for them.
Consider easy ways to make payments, such as electronic payments via ACH.
Being a plan sponsor comes with a lot of responsibilities. But with the right education (and expert knowledge from your advisors!), you can create and offer a retirement plan that your participants love.
FAQs
What is a 401(k) loan?
A 401(k) loan is when a participant borrows against the funds in their 401(k) account. Unlike regular loans, the borrower is borrowing from themselves and repays the money back to their own account with interest paid back into their own 401(k) account. Participants generally have up to five years to repay the loan.
How much can a participant borrow from their 401(k)?
Participants can borrow up to 50% of their vested 401(k) balance, with a maximum cap of $50,000. This amount is also reduced by the highest outstanding loan balance in the past 12 months.
What's the difference between a 401(k) loan and a hardship withdrawal?
A 401(k) loan must be repaid and generally can be used for any purpose. A hardship withdrawal is a one-time withdrawal for specific qualified expenses (medical, housing, education, etc.) that cannot be repaid and cannot be rolled over to another retirement plan.
What happens if an employee with a 401(k) loan leaves the company?
The loan policy may require immediate repayment of the outstanding balance. If the employee cannot repay, they may be able to roll over the loan to an eligible retirement plan,if both plans allow, the amount may be rolled into an IRA or eligible retirement plan, or the loan may be treated as a taxable distribution.
What are the employer's responsibilities for 401(k) loans?
Employers must set a reasonable interest rate, establish a repayment plan with at least quarterly payments, maintain proper documentation, and ensure loans don't exceed maximum limits. The loan policy should be clearly communicated to participants.
Disclosures
¹ For informational purposes only. This should not be considered financial, tax, or legal advice. Contact a financial professional to evaluate what retirement plan is best suited for your situation.
2 The regulations allow a participant to borrow up to $10,000, even if that exceeds 50% of their vested account balance (but never more than 100% of their vested account balance). This feature is optional, not required, and most plans don't offer it, because any amount above 50% of the vested balance must be secured by collateral other than the participant's plan account, which most plans aren't set up to accept.
3 This content is for informational purposes only and is not intended to be taken as tax advice. Please contact a tax professional for further information.
4 This content is for informational purposes only and is not intended to be construed as tax or investment advice. You should consult a tax professional or financial advisor to consider all alternative options. Investing involves risk, and investments may lose value, including loss of principal.
