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401(k) Loan Administration: Repayments, Leave, Defaults and Deemed Distributions

9/30/2026

A 401(k) loan is approved by the recordkeeper, governed by the plan document and the tax code, and repaid almost entirely through payroll. That last part is where it goes wrong. The loan itself is rarely the problem. The problem is a repayment deduction that stops during a leave and never restarts, a final paycheck that takes the wrong amount, or a repayment that sits in the operating account for two weeks before it reaches the trust.

Our 401(k) payroll handbook gives loans a short section. This page goes deeper on loan servicing from payroll's side: the rules that shape the repayment schedule, what happens during leave and military service, how a missed payment turns into a taxable deemed distribution, and what termination does to an outstanding loan.

The Federal Framework in One Section

Plan loans are an exception to the general rule that a loan from a qualified plan is taxed as a distribution. Internal Revenue Code section 72(p) and the regulations at Treas. Reg. 1.72(p)-1 set the conditions. A loan that meets them is not taxable; a loan that fails them, in form or in operation, becomes a deemed distribution.

The conditions payroll needs to understand:

Requirement

Rule

Maximum amount

The lesser of $50,000 or the greater of $10,000 or 50% of the vested account balance

Multiple loans

The $50,000 is reduced by the highest outstanding loan balance during the prior 12 months, minus the current balance

Term

Repaid within 5 years, except a loan used to buy the participant's principal residence

Repayment pattern

Substantially level amortization, with payments at least quarterly

 

The plan document can be stricter than the law. Many plans limit the number of outstanding loans, set a minimum loan amount, or require repayment by payroll deduction only. Payroll should work from the plan's loan policy, not from the statutory maximums.

The quarterly minimum matters more than it looks. Payroll deducts every pay period, so a normal loan is far more frequent than the law requires. But the statutory floor is what defines when a gap in payments becomes a failure, which is why a missed deduction is not automatically a deemed distribution.

Setting Up the Repayment Deduction

When a loan is issued, the recordkeeper produces an amortization schedule and sends payroll the per-pay-period repayment amount, usually through the regular deduction feed. Payroll's job is to start the deduction on the right pay date, at the right amount, and keep it there.

Points worth building into the setup:

  • Start date. The first deduction should begin on the pay date the amortization schedule assumes. A delayed start throws the schedule off from the first payment.
  • Deduction type. Loan repayments are after-tax. They do not reduce income tax or FICA wages, and they are not deferrals, so they do not count against the deferral limit. See our pre-tax vs. post-tax deductions guide for where they sit in the deduction order.
  • One code per loan. A participant with two loans needs two deduction codes, or a mapping the recordkeeper can split. Combining them into one deduction makes it impossible to tell which loan is short.
  • Most plans have the participant authorize payroll repayment in the loan documents. Keep a copy, or confirm the recordkeeper holds it. Our voluntary deduction authorization guide covers the state-law side of written authorizations.
  • Pay frequency changes. If an employee moves from biweekly to semimonthly, the per-period amount changes. The recordkeeper must re-amortize; payroll must not simply carry the old amount over.

Repayments Are Plan Assets

A loan repayment withheld from pay becomes a plan asset on the same timing rule as a deferral. The DOL's plan asset regulation at 29 CFR 2510.3-102 expressly covers amounts withheld "for contribution or repayment of a participant loan." Remit loan repayments with the deferrals, on the same file and the same day. A late repayment is a prohibited transaction requiring lost earnings and excise tax correction, exactly like a late deferral.

Leave of Absence: Suspension Without Default

Unpaid leave is the single biggest cause of loan defaults that should never have happened. The deduction stops because there is no pay, nobody tells the recordkeeper, and by the time the employee returns, the cure period has run.

The regulations give plans a way to prevent this. Under Treas. Reg. 1.72(p)-1, Q&A-9, the level amortization requirement does not apply for a period of up to one year while a participant is on a bona fide leave of absence that is unpaid, or paid at a rate (after withholding) less than the installment amount. Two conditions attach:

  • The loan, including interest that accrued during the leave, must still be repaid by the latest permissible term, generally five years from the loan date.
  • When repayments resume, the installments cannot be less than the original installments.

In practice, that means the recordkeeper re-amortizes at the end of the leave, and the new payment is higher, because the same balance plus accrued interest is now repaid over a shorter remaining term. Payroll has to load the new amount, not resume the old one.

Whether suspension is available depends on the plan. The regulation permits it; the plan's loan policy decides whether and how it applies. Check before the leave starts.

Payroll's Leave Checklist for Loans

  1. When an unpaid or reduced-pay leave begins, identify every employee with an active loan.
  2. Notify the recordkeeper of the leave start date, so the suspension is recorded rather than the payments simply missing.
  3. Decide whether partial pay covers the installment. If the employee receives reduced pay, short-term disability through payroll, or intermittent pay, the deduction may continue. Our FMLA intermittent leave payroll guide covers how partial pay periods flow through payroll.
  4. Track the 12-month limit. A suspension cannot exceed one year under this rule (military service is treated separately).
  5. On return, get a re-amortized schedule from the recordkeeper before the first full paycheck, and load the new amount.
  6. Confirm the first post-leave deduction actually ran.

Step five is where most failures occur. The employee returns, payroll reactivates the old deduction, and the loan is now on track to miss its maximum term.

Military Leave: A Different Rule

Military service is handled separately. Under Q&A-9(b), if a plan suspends repayments while a participant performs service in the uniformed services, as USERRA and Internal Revenue Code section 414(u) contemplate, the suspension does not cause a deemed distribution even if it lasts longer than one year, and the maximum term is extended by the period of military service.

When service ends, repayments resume, and the loan, with interest, must be repaid in substantially level installments by the end of the original term plus the period of service.

Separately, the Servicemembers Civil Relief Act limits interest on obligations incurred before military service to 6% during the service period, and the regulations recognize that rate for plan loans during military leave. The recordkeeper applies the interest change; payroll's job is to report the leave promptly and to restart repayments at the re-amortized amount when the service member returns.

Missed Payments, the Cure Period and Default

Not every missed deduction is a default. A payroll glitch, a short paycheck, or a pay period with no hours can leave a gap, and the regulations allow a plan to give the participant time to catch up.

Under Q&A-10, a plan may provide a cure period, which can continue no later than the last day of the calendar quarter following the calendar quarter in which the missed installment was due. A payment missed in February (first quarter) can be cured through 30 June (the end of the second quarter), if the plan's policy provides the maximum cure period. Some plans provide less.

If the missed installments are not made up by the end of the cure period, the entire outstanding balance, including accrued interest, becomes a deemed distribution at that point. Not just the missed payments: the whole loan.

That is why missed deductions must be reported to the recordkeeper quickly. A missed payment the recordkeeper never hears about cannot be cured, and the participant learns about it from a Form 1099-R.

What a Deemed Distribution Does

A deemed distribution is a tax event, not a cash event. Under Q&A-12 and Q&A-13, it is treated as a distribution for certain tax purposes, but:

  • It is not an actual distribution of the participant's account. The loan stays on the plan's books.
  • It is not eligible for rollover.
  • It is reported on Form 1099-R with code L in box 7. The IRS instructions say code L is for loans treated as deemed distributions and must not be used for a loan offset.
  • The participant may owe the additional 10% tax on early distributions if under the applicable age, depending on the exception rules.

And the loan does not go away. Under Q&A-19, a deemed-distributed loan that has not been repaid is still treated as outstanding when calculating the maximum for any later loan, and any later loan requires repayment by payroll withholding or additional collateral. The participant can also continue repaying it, which creates tax basis.

On withholding: under Q&A-15, the amount included in income on a deemed distribution or offset is subject to withholding, but withholding applies only to the extent cash or property is distributed at the same time. A deemed distribution by itself involves no cash, so typically nothing is withheld.

Termination: Offsets and the Final Paycheck

When a participant with an outstanding loan leaves employment, payroll repayment ends. What happens next depends on the plan's loan policy.

Repayment options after termination. Some plans let former employees keep repaying directly, by ACH or coupon. Others require the loan to be repaid in full within a set period or declare it due on termination.

Final paycheck deductions. Taking the full loan balance out of a final paycheck is rarely possible and may be prohibited by state final pay and wage deduction rules. Take only the scheduled installment unless the plan and the employee's written authorization specifically permit more, and the applicable state rules allow it. See our final paycheck requirements by state.

The loan offset. If the loan is not repaid, the plan typically reduces the participant's account balance by the outstanding loan amount when a distribution is permitted. That is a plan loan offset, and under the regulations it is an actual distribution, not a deemed distribution.

Qualified plan loan offsets. A loan offset that occurs solely because the plan terminated, or because the participant failed to meet the repayment terms due to severance from employment, while the loan was in good standing, is a qualified plan loan offset. The participant can roll the offset amount over by contributing an equal amount to an IRA or another plan by the due date, including extensions, of the federal income tax return for the year of the offset, instead of the usual 60 days. It is reported on Form 1099-R as an actual distribution with code M in box 7.

The offset itself is the recordkeeper's to process and report. Payroll's role is to report the termination date promptly and accurately, because the date drives whether an offset is "qualified" and when the reporting falls.

Spousal Consent on Loans

If a plan is subject to the qualified joint and survivor annuity rules, which applies to money purchase plans and some 401(k) plans that offer annuity forms, using the participant's account as security for a loan requires spousal consent. Under Internal Revenue Code section 417(a)(4) and Treas. Reg. 1.401(a)-20, Q&A-24, the consent must be obtained within the 90-day period ending on the date the loan is secured. The IRS has noted that proposed regulations would extend that window, but confirm the current rule in your plan's procedures. Most 401(k) plans that are not subject to the annuity rules do not require spousal consent for loans. This is the recordkeeper's to administer, but payroll should know it exists when a participant asks why their loan is delayed.

A Payroll Control Set for Loans

  • Reconcile loan deductions to the recordkeeper's expected repayments every pay date. Any participant with a scheduled payment and no deduction should be on an exception report.
  • Remit repayments with deferrals, on the same file and same day.
  • Build leave triggers. When an employee goes on unpaid or reduced-pay leave, check for loans automatically.
  • Build return triggers. On return, require a re-amortized schedule before the first full pay.
  • Never re-key amounts from memory. Load per-period amounts from the recordkeeper's file.
  • Watch pay frequency and job changes, which change installment amounts.
  • Report terminations the day they happen.
  • Escalate garnishment conflicts. When a garnishment or levy reduces net pay below the loan installment, the order of priority matters. Our employer's guide to wage garnishments covers how disposable earnings are calculated and why plan loan repayments are generally not deducted before the garnishment calculation.

The Plan Loans Training and Certification Program is the specialist certification for this area, for payroll and benefits staff who service loans day to day and want the plan-side rules behind the deductions they run.

Frequently Asked Questions

What is 401(k) loan administration?

The work of setting up, servicing and closing out participant loans: approving loans within the plan's policy and the section 72(p) limits, amortizing them, collecting repayments (usually through payroll), handling leave and military suspensions, administering cure periods, and reporting defaults and offsets on Form 1099-R. The recordkeeper typically handles approval and reporting, while payroll handles the repayment deduction and the timely remittance of repayments to the plan, which the DOL treats as plan assets.

What happens to a 401(k) loan during an unpaid leave of absence?

If the plan permits, repayments can be suspended for up to one year during a bona fide unpaid leave, or a leave paid at less than the installment amount, under Treas. Reg. 1.72(p)-1, Q&A-9. The loan plus interest accrued during the leave must still be repaid by the original maximum term, and post-leave installments cannot be smaller than the original ones. The recordkeeper re-amortizes, and payroll must load the higher amount on return.

How does the cure period work for missed 401(k) loan payments?

A plan may allow a participant to make up a missed installment within a cure period that can last no later than the end of the calendar quarter following the quarter in which the payment was due. If the missed payments are not made up by then, the entire outstanding balance, including accrued interest, becomes a deemed distribution. Plans can set a shorter cure period, so check the loan policy.

What is the difference between a deemed distribution and a loan offset?

A deemed distribution happens when the loan fails the section 72(p) rules, usually from missed payments. It is taxable, not eligible for rollover, reported with code L, and the loan stays outstanding on the plan's books. A loan offset reduces the actual account balance to repay the loan, typically after termination. It is an actual distribution, and a qualified plan loan offset can be rolled over until the tax return due date, including extensions.

Are 401(k) loan repayments subject to deposit timing rules?

Yes. The DOL's plan asset regulation covers amounts withheld from wages for repayment of a participant loan on the same basis as deferrals. Repayments must be remitted as soon as they can reasonably be segregated from the employer's general assets. A late repayment is a prohibited transaction, corrected with lost earnings and excise tax, and eligible for the DOL's Voluntary Fiduciary Correction Program, including its self-correction component when the conditions are met.

What happens to a 401(k) loan when an employee quits?

Payroll repayment ends, and the plan's loan policy decides the rest. Some plans allow continued direct repayment; others require repayment in full within a set period. If the loan is not repaid, the plan usually offsets the account balance. An offset caused by severance from employment, on a loan in good standing, is a qualified plan loan offset the participant can roll over by the tax return due date, including extensions.

Servicing Loans Without Surprises

Most loan defaults that reach a participant's tax return start with something payroll could have caught: a missed deduction nobody reported, a leave nobody flagged, a return-to-work amount nobody updated. The Plan Loans Training and Certification Program is the place to build that knowledge, and the 401(k) Training and Certification Program covers the wider plan in which loans sit.

Loan limits, cure periods and suspension rights depend on both federal rules and your plan's own loan policy, which can be stricter. Confirm the policy with your recordkeeper before changing a deduction, and coordinate any correction with the plan administrator.