Plan Loan
A plan loan is a provision in many 401(k) and other qualified retirement plans that allows participants to borrow from their own vested account balance, subject to IRS limits and repayment requirements, without incurring income tax or the 10% early withdrawal penalty at the time of borrowing.
Plan loans are authorized by IRC Section 72(p) and are permitted (but not required) in employer-sponsored defined contribution plans. Not all plans offer this feature — the plan document must specifically allow loans, and the plan administrator establishes the terms within the IRS parameters. IRAs, by contrast, do not permit loans; any transfer of IRA assets to the account owner that is not completed as a proper rollover is treated as a taxable distribution.
The IRS limits the loan amount to the lesser of $50,000 or 50% of the participant's vested account balance. If the vested balance is $20,000 or less, the participant can borrow up to $10,000 regardless of the 50% limitation. The $50,000 limit is reduced by the highest outstanding loan balance during the 12-month period ending the day before the new loan is taken. Most plans limit participants to one or two outstanding loans at a time, though plan documents vary.
Repayment must be made in substantially level installments (at least quarterly) over a maximum of five years, with the exception that loans used to purchase a principal residence can have a repayment period exceeding five years. The interest rate must be a reasonable commercial rate, and interest paid by the participant is credited back to their own account rather than going to the plan or the plan sponsor — the participant effectively pays interest to themselves.
The primary risks associated with plan loans relate to default and opportunity cost. If the participant leaves the employer — whether voluntarily or involuntarily — the outstanding loan balance is typically due in full by the tax filing deadline (including extensions) for the year of separation under rules updated by the Tax Cuts and Jobs Act of 2017. Previously, the repayment deadline was 60 days after separation. If the loan is not repaid by the deadline, it is treated as a deemed distribution, subject to ordinary income tax and, if the participant is under age 59½, the 10% early withdrawal penalty.
The opportunity cost of a plan loan is often underappreciated. While the loan is outstanding, the borrowed funds are not invested in the market — they are replaced on the participant's balance sheet by a loan receivable. During periods of strong market performance, this missed investment return can significantly exceed the interest rate paid. If the participant reduces or suspends contributions to afford the loan repayments, the compounding impact of reduced contributions further erodes long-term account growth.