401(k) loan

What a 401(k) loan is

A plan may allow participants to borrow from their accounts. Loans are optional, and the plan document and a written loan policy set the terms. The tax code sets the outer limits:

• Amount: the lesser of $50,000 or 50% of the vested balance. A plan may let someone with a small balance borrow up to $10,000.

• Term: five years at most, unless the loan is used to buy the participant’s main home.

• Repayment: substantially level payments, made at least quarterly.

A loan that meets these rules is not taxable. The participant repays principal and interest into their own account.

Why it matters to employers

Loans run through your payroll. You have to start deductions on time, send them with each payroll and keep them going through leaves and pay changes. A missed payment that is not caught up within the plan’s cure period, which can run no later than the end of the following calendar quarter, puts the loan in default. The outstanding balance is then a “deemed distribution”, taxable to the participant and possibly subject to the 10% additional tax.

When an employee leaves with a loan outstanding, most plans offset the unpaid balance against their account. The former employee has until their tax return due date, with extensions, to roll over that amount and avoid tax.

Example

A participant has a vested balance of $60,000. The most she can borrow is $30,000. With a vested balance of $150,000, the limit is $50,000.

Common mistakes

• Missing loan deductions after a payroll system change.

• Allowing more loans, or longer terms, than the loan policy permits.

• Not reducing the $50,000 limit for a participant who had another loan in the past 12 months.

• Failing to report a defaulted loan on Form 1099-R.

• Forgetting spousal consent where the plan requires it.