Income and Assets · Retirement income

Loans from qualified plans

Start from the right default. IRC § 72(p)(1)(A) says that if a participant receives any amount as a loan from a qualified employer plan, that amount is a distribution. Everything practitioners think of as “the plan loan rules” is the exception in § 72(p)(2), and a loan that misses any one of its conditions falls back to the rule. What makes the failure painful is what happens next: the tax is charged, the account balance is not reduced, the participant still owes the plan, and nothing can be rolled over to undo it.

The rule

A loan is a distribution, and so is a pledge. Any amount received directly or indirectly as a loan from a qualified employer plan is treated as received as a distribution (IRC § 72(p)(1)(A)); assigning or pledging any portion of an interest in the plan is treated as receiving a loan of that portion (§ 72(p)(1)(B)). A qualified employer plan means a § 401(a) plan with an exempt trust, a § 403(a) annuity plan, or a § 403(b) arrangement (§ 72(p)(4)(A)(i)) — which is why the question never arises for an IRA.

The exception has a ceiling with two limbs. Paragraph (1) does not apply to the extent the loan, added to the outstanding balance of all other loans from the plan, does not exceed the lesser of a fixed statutory cap reduced by the excess of the highest outstanding balance during the year ending the day before the loan over the balance on the day of the loan, or the greater of half the present value of the nonforfeitable accrued benefit and a floor — both figures are in the table below (IRC § 72(p)(2)(A)(i), (ii)). The look-back in clause (i) is what stops a participant from repaying a loan in December and borrowing the full amount again in January.

Three more conditions. The loan must by its terms be repayable within five years, unless used to acquire a dwelling unit that within a reasonable time is to be the participant’s principal residence — tested when the loan is made (IRC § 72(p)(2)(B)). It must require substantially level amortization with payments at least quarterly (§ 72(p)(2)(C)). And it must not be made through a credit card or any similar arrangement (§ 72(p)(2)(D)).

Plans of one employer are one plan. The controlled group, common control and affiliated service group rules of § 414(b), (c) and (m) apply, and all plans of an employer determined after applying them are treated as one plan (IRC § 72(p)(2)(E)).

Failure produces a deemed distribution, and its timing depends on how it failed. Where the terms do not satisfy the repayment-term or level-amortization requirement, or there is no enforceable agreement, the entire loan is deemed distributed when made. Where the terms are fine but the amount exceeds the ceiling, only the excess is deemed distributed when made. Where the loan was sound but payments stop, the deemed distribution occurs on the failure to pay (Reg. § 1.72(p)-1, A-4(a)). A plan administrator may allow a cure period, but it cannot run past the last day of the calendar quarter following the quarter in which the missed installment was due (A-10(a)).

A deemed distribution is taxed but is not a distribution. Section 72 applies to it as if it were an actual distribution, and so does the additional tax on early distributions under § 72(t) (Reg. § 1.72(p)-1, A-11(a), (b)). But it is not treated as an actual distribution for the qualification rules, the distribution restrictions or § 402 — so it is not eligible for rollover (A-12), and it is not a reduction of the accrued benefit (A-13(a)(2)). The participant is taxed on money that is still in the plan and still owed to it. Repayments made after a deemed distribution do increase the participant’s investment in the contract, so the same dollars are not taxed twice on the way out (A-21(a)).

An offset is the opposite: real money, and rollable. A plan loan offset occurs where the accrued benefit is actually reduced to repay the loan (Reg. § 1.72(p)-1, A-13(a)(2)). Where that offset arises solely from termination of the plan or from failure to meet the repayment terms because of severance from employment, it is a qualified plan loan offset amount, and the 60-day rollover deadline is replaced by the due date, including extensions, for the return for the year of the distribution (IRC § 402(c)(3)(C)(i), (ii)). That relief is available only where the loan itself satisfied § 72(p)(2) (§ 402(c)(3)(C)(iv)).

Interest is usually not deductible. No deduction is allowed for interest on a § 72(p)(2) loan for any period on or after the first day the borrower is a key employee within § 416(i), or where the loan is secured by amounts attributable to elective deferrals (IRC § 72(p)(3)).

The loan must also clear § 4975. Lending between a plan and a participant is a prohibited transaction unless the § 4975(d)(1) exemption is met: available to all participants on a reasonably equivalent basis, not more generous to highly compensated employees, made under specific plan provisions, bearing a reasonable rate of interest, and adequately secured.

Current figures

How it works in practice

Test the ceiling in the order the statute writes it. Take the smaller of the two limbs, not the larger: the capped limb is an outer boundary and the accrued-benefit limb is usually the binding one for a modest balance. Then reduce the capped limb by the look-back figure. A participant whose balance is small enough that half of it falls under the floor may still borrow up to that floor, because clause (ii) takes the greater of the two — the only place in the computation where “greater” appears.

Then read the plan document, because none of this compels a plan to offer loans at all, and most plans impose tighter terms than the statute requires. Section 72(p) sets an outer boundary; the plan sets the actual one, and a loan that breaches the plan’s own terms is a loan not made in accordance with specific plan provisions for § 4975(d)(1)(C) purposes.

The reporting follows the character. A deemed distribution is reported for the year of the failure and taxed then, with the additional tax if applicable. An offset is reported too, but a qualified offset may be replaced out of other funds until the extended due date of that year’s return.

How this has changed

The rollover window for offsets was rewritten and is now statutory. Before it was added, a participant whose account was offset on severance had 60 days to find the money — which is precisely the period in which a person who has just lost a job does not have it. IRC § 402(c)(3)(C) replaced that with the extended due date of the return, but only for an offset caused by plan termination or severance, and only where the loan satisfied § 72(p)(2). An offset arising for any other reason still runs on 60 days.

Disaster loan relief became a standing rule. IRC § 72(p)(6) now sits in the Code rather than in successive one-off statutes: for a qualified individual borrowing during the applicable period for a qualified disaster, the statutory cap doubles, the one-half limb becomes the whole nonforfeitable accrued benefit, and repayments falling due in the relief period may be delayed a year with the delay disregarded in measuring the five-year term. Older material treats each disaster as needing its own Act; it no longer does.

The regulation has not moved, and that matters. Treas. Reg. § 1.72(p)-1 is still in its original question-and-answer form, and its A-4, A-10, A-12, A-13 and A-21 remain the operative authority on when a deemed distribution occurs, what curing it means, and how it differs from an offset. Where a statement about plan loans cannot be traced to § 72(p) itself, it almost always traces to one of those answers.

Exam focus

Expect the ceiling to be computed, with a look-back designed to catch a candidate who applies the statutory cap flat. Read for a prior loan in the preceding twelve months, and read whether the balance is small enough for the floor in clause (ii) to matter.

Expect the deemed distribution versus offset distinction, because it decides both whether a rollover is possible and whether the account balance changed. The signal words are “the plan reduced her account” for an offset and “the loan was treated as distributed” for a deemed distribution.

Expect § 72(t) to ride along. A deemed distribution to a participant under 59½ carries the additional tax unless an exception in § 72(t)(2) applies; separation from service at 55 or later is one that often does.

Watch for an IRA in the facts. There is no such thing as an IRA loan, and the consequence of trying is not a deemed distribution but loss of the account’s status under § 408(e)(2).

Check yourself

1. A participant with a vested balance of 16,000 dollars and no prior loans asks for the largest permitted loan. What is it?

Answer: 10,000 dollars. IRC § 72(p)(2)(A)(ii) takes the greater of half the nonforfeitable accrued benefit (8,000 dollars) or the statutory floor of 10,000 dollars, and the capped limb of clause (i) is not binding.

2. A loan is written with annual payments over four years. What is the consequence, and when?

Answer: The entire loan is a deemed distribution at the time it is made. Annual payments fail the level-amortization requirement of § 72(p)(2)(C), which demands payments at least quarterly, and Reg. § 1.72(p)-1, A-4(a) places the deemed distribution at the time the loan is made where the terms are defective.

3. After a deemed distribution, does the participant’s account balance fall, and can the amount be rolled over?

Answer: No to both. A deemed distribution is not a distribution of the accrued benefit (Reg. § 1.72(p)-1, A-13(a)(2)) and is not eligible for rollover (A-12). The participant is taxed while the money remains in the plan and the obligation remains outstanding.

4. Two participants are each offset 20,000 dollars in 2026 — one on severance from employment, one on taking an in-service distribution that the plan’s terms required the loan to be repaid from. Do they have the same rollover deadline?

Answer: No. The severance offset is a qualified plan loan offset amount under § 402(c)(3)(C)(ii)(II) and may be rolled over until the extended due date of the 2026 return. The other is an ordinary offset on the usual 60-day rule.

5. A client who is the sole shareholder and only employee of an S corporation asks whether she may borrow from the corporation’s 401(k) plan. May she?

Answer: Yes, if the plan permits it and the § 4975(d)(1) conditions are met. IRC § 4975(f)(6)(B)(iii) limits the owner-employee restriction on plan loans to participants in individual retirement plans, so a shareholder-employee is not barred.