Can i pay a 401k loan off early

Facts

A participant in our 401(k) plan took out a loan a couple years ago. She could only afford to make the bare minimum payments at the time, but is now in a financial position to pay down the loan more quickly.

Question

Is it alright for a participant to make extra payments on his or her loan in order to expedite pay-off?

Answer

It is theoretically possible for a participant to make extra payments on a 401(k) loan, but trying to implement that can be somewhat impractical.

The first order of business is to check your plan document and loan policy to see what it says. Many are written to say that pre-payments are only allowed if the loan is being repaid in full. In other words, it would not be allowed to pay a little extra here and there. In that situation, the participant could set aside the extra in a savings account or something like that. When he or she has accumulated enough, the loan could then be repaid in full.

Another thing to check is whether plan documents require that payments be made via payroll deduction. If so, the only way a participant could make additional payments would be to adjust withholding on the applicable paychecks. That, of course, is possible, but it could certainly cause administrative headache.

If the plan documents do not contain that type of limitation, the second step is to find out what the plan’s record keeper can accommodate in terms of applying the extra payment amount. With the typical loan, additional amounts paid over and above the regular periodic payment are applied to the principal balance of the loan. Not only does that reduce the outstanding balance, but it also reduces future interest accruals.

Many 401(k) record keeping systems, however, are not able to deviate from the amortization schedule that was created at the beginning of the loan. In those cases, the common practice is for the record keeper to hold the extra amounts and apply them to regularly scheduled future payments.

As an example, let’s assume I have a loan with semi-monthly payments of $50 each. On June 1, I triple-up and send in payments of $150. Rather than applying $50 to my regularly scheduled payment and the remaining $100 as a reduction in principal, the record keeping system simply applies the $150 so that it covers the next three regularly scheduled payments. My loan does not get paid down any faster, and I do not save any interest. If there is no savings and the loan is not being paid off any faster, a participant probably will not be as inclined to make additional payments.

So, the answer is not “no," but this is one of those cases where a “yes” answer isn’t all it’s cracked up to be.

For more information on qualified plan compliance, visit our Knowledge Center.

Topics: 401(k) Plan, Question of the Week (QOTW), DWC, Participant Loans, Plan Compliance

by Schneider-Photographie

If you already are paying on a loan from your 401(k) account and lose your job amid the coronavirus pandemic, that borrowed money could generate a tax bill you weren't expecting.

Although the latest round of economic rescue legislation provides relief for coronavirus-related withdrawals from 401(k) plans, loans that already have been in repayment are subject to some existing rules that apply when you're laid off or otherwise part ways with your company. In other words, your loan could morph into a distribution that comes with taxes and an early withdrawal penalty.

"If an individual is laid off, it can speed up the time of repayment," said Will Hansen, executive director of the Plan Sponsor Council of America. 

Although the CARES Act makes some changes to 401(k) withdrawals and loans for individuals financially impacted from the coronavirus — including waiving early withdrawal penalties and giving qualifying individuals three years to replace what they took out — the legislation does not cover loans unrelated to the current crisis. That includes ones that already were outstanding.

As the coronavirus pandemic continues running roughshod over the U.S. economy and job losses continue to mount, some workers may hit the unemployment line with a 401(k) loan in tow. Vanguard's 2019 How America Saves report shows that 13% of 401(k) savers have an outstanding loan.

The average balance on those loans is $9,900 and is most common among workers with income from $30,000 to $100,000. About 78% of plans allow such loans, whose repayment terms are usually five years.

Federal law allows workers to borrow up to 50% of their account balance, with a maximum of $50,000 (the CARES Act temporarily increased that to $100,000 for individuals who are financially impacted by the coronavirus pandemic). The loan is tax-free and, unlike with most outright distributions, there is no early withdrawal penalty of 10% if you're under age 59½.

However, if you leave your job — whether by choice or not — there's a good chance your plan will require you to repay the money back fairly quickly; otherwise, your account balance will be reduced by the amount owed and considered a distribution.

Unless you are able to come up with that amount and put it in a qualifying retirement account, that distribution is taxable. And, if you are under age 55 when you leave the job, you'll pay a 10% early withdrawal penalty. (Workers who leave their company when they reach that age are subject to different withdrawal rules for 401(k) plans).

"A participant who does not repay an outstanding loan will be taxed on the loan as if it were a cash distribution," said Marcia Wagner, founder of The Wagner Law Group and an expert in employee benefits.

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You get until tax day the following year to replace the amount — i.e., if you are laid off in April 2020, you get until April 15, 2021, to come up with the funds. Prior to major tax law changes that took effect in 2018, participants only had 60 days.

Although most plans won't let you continue paying the loan after you leave the company, it's worthwhile checking on the policy for your 401(k) plan.

"There are some plans that let you continue to repay the loan even after termination," said Brian Pinheiro, a partner in the Philadelphia office of law firm Ballard Spahr and an expert on federal retirement law.

For retirement savers who remain employed but are struggling to make payments on their 401(k) loan, the CARES Act allows you to defer payments for one year.

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