Loan Interrupted: What Happens to a Defaulted Plan Loan?

Jun 24, 2021

Most defined contribution retirement plans, like 401(k) plans, allow plan participants to take a loan from their plan account. One reason for the popularity of the plan loan feature is that workers may be more likely to participate in the employer's plan if they know they can access their savings before retirement if a need arises. When a plan loan complies with the tax laws and the plan’s loan policy, it is repaid on schedule and the participant restores their savings, with interest, to their plan account. When something goes awry, such as a missed payment that is not made up, the plan loan is in default. To keep the plan in compliance, plan sponsors that allow plan loans must understand the loan rules and what happens when a loan is in default.

Regulatory Requirements

401(k) plans may allow plan participants (including business owners) to take loans from their vested plan assets. However, plan loans must meet the following regulatory requirements to avoid being treated as a taxable distribution from the plan:

  • There must be a written loan agreement between the plan and the participant (may be electronic).
  • A commercially reasonable interest rate must be applied to the loan.
  • Loan repayments must be made in level amortized payments at least quarterly.
  • The loan must be repaid within five years from the date the loan is made, unless the loan is used to purchase a primary residence.
  • The loan amount (when combined with all other loans to the participant from plans sponsored by the same or a related employer) cannot exceed 50% of the participant’s vested account balance, or $50,000, whichever amount is less. The maximum loan amount must be further reduced if the participant had any outstanding loans within 12 months prior to the loan. 

Plan Policies

Plan sponsors may place additional restrictions on plan loans by making elections in their plan document or by adopting a written loan policy. For example, a loan policy may require loans to be repaid through payroll deduction, limit the number of loans participants can have at one time, or require married participants to obtain spousal consent for a loan.  A plan can also require loans to be paid in full upon termination of employment and set the “cure period” (within regulatory limits) for making up any missed payments.

The Cure Period

One of the most common causes of defaulted plan loans is missed loan payments. A plan may provide time, called a cure period, for the participant (or payroll department if administrative error) to make up the missed payment. The maximum time that may be allowed is the end of the calendar quarter following the quarter in which the payment was missed.

For example, if a participant is making monthly loan payments and misses the March payment, the participant would have until June 30 to make up the missed payment and avoid default. A plan sponsor may set a shorter cure period or not allow for a cure period. For missed repayments, the plan sponsor may allow the loan to be re-amortized in addition to or in lieu of making up missed payments.

Deemed Distributions Are Taxable

If missed repayments are not made up by the end of the cure period, and the participant does not have a distribution-triggering event, the plan sponsor must direct the recordkeeper to process the defaulted loan as a deemed distribution. The outstanding loan balance and interest will be reported on IRS Form 1099-R as a taxable distribution (excluding basis).

If the participant is younger than age 59½, the taxable amount will also be subject to the 10% early distribution tax unless the participant meets an exception. A deemed distribution is not eligible to be rolled over to another plan or IRA. The outstanding loan balance “stays on the books” of the plan. The participant may make loan repayments after a deemed distribution has occurred, but the late repayments will be tracked as basis in the account. 

Offsets May Be Taxable or Rolled Over

If the participant who has missed a loan payment is eligible to take a distribution from the plan and requests a distribution before the end of the cure period, the participant’s account balance may be reduced, or offset, by the unpaid portion of the loan. The plan loan offset amount is treated as an actual distribution and may not be paid back to the plan. It will be reported on Form 1099-R as a distribution, is taxable to the participant, and eligible for rollover. Participants have 60 days from the date of the loan offset to roll over the offset amount to avoid taxation on the distribution.  
If a plan loan offset is “qualified,” the participant will have a much longer time to roll over the outstanding loan balance to another plan or IRA. Participants have until their federal income tax return due date, including extensions, for the year in which the offset occurred to complete a rollover of a qualified plan loan offset and avoid taxation on the offset amount. To be a qualified plan loan offset:

  • The loan must be in good standing as of the date of employment or plan termination
  • The offset must be due solely to termination of employment or plan termination, and
  • For offsets triggered by termination of employment, the offset must occur within one year of termination.

The plan loan offset amount is treated as an actual distribution and is eligible for the extended rollover period.

Repayment Relief in Special Situations

The tax laws permit repayment relief for those on military leave or on unpaid leaves of absence. In addition, special relief may be granted by federal agencies in the event of a federally declared disaster or for other extraordinary circumstances.  For example, as a result of COVID-19, the IRS granted special relief allowing the delay of certain loan repayments through mid-July 2020.  Also, under the CARES Act, plan sponsors could make loan payment relief available to participants who met certain eligibility requirements, allowing loans in good standing before March 27, 2020 to defer payments during 2020.  For plans offering CARES Act loan relief, the participant may have an extended cure period as late as June 30, 2021.

If you have questions about the loan rules or administering your loan program, particularly considering the CARES Act relief, please refer to the loan cure information provided quarterly by Newport, or contact your Newport Representative for assistance.


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