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Loan payment following termination


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I have a participant that terminated employment in 2015.     The employer allowed him to make personal payments on his 401k loan.    The last payment he made was in January 2017 and according to the recordkeeper's amortization schedule that payment paid the loan up to April 2018.     Now he wants to make another payment.    Can he still do that since it's been over a year?   I thought there had to be at least a quarterly payment.  

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You have to look at the terms of the loan to determine the payment schedule (which must provide for at least quarterly payments), and, more important under the circumstances, the treatment of prepayments.  Applying a prepayment to future amounts due as they become due is unusual, and perhaps improper for a 401(k) plan loan.  I would not know what to do with the amounts not yet applied to the loan.  More conventional is that the excess over the amount due reduces principal, which then shortens the payment schedule, but does not change the requirement to make a payment on the next scheduled payment date.  If the loan terms treat a prepayment in the conventional way, the failure to make a payment on the next payment date (not more than a quarter after the January  2017 payment) is a default.  Then check the terms concerning default.  Allowing the loan to be "paid up" until April 2018 probably violated loan terms, no matter what the good intentions and apparent lack of harm or shortfall of payments.  That is the likely problem, not a violation of the "at least quarterly" payment rule.  That rule is for design of loan terms.   The loan was probably designed properly.

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It sounds like this was a prepayment, and that the new payment now would be a prepayment. That usually is permitted under the loan policy and would also not violate 72(p). The loan schedule amortized over 5 years at least quarterly. He's just paying ahead of the amortization schedule.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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17 hours ago, Luke Bailey said:

It sounds like this was a prepayment, and that the new payment now would be a prepayment. That usually is permitted under the loan policy and would also not violate 72(p). The loan schedule amortized over 5 years at least quarterly. He's just paying ahead of the amortization schedule.

I agree.  If you were to match up the amortization schedule with the actual payments, they would all be on time. 

But...QDROphile makes a good point.  There is a distinction between a "pre"payment and "extra" payment.  If you wind up reducing the total amount of interest paid because of these payments, then they should probably be treated at "extra" payments and that means subsequent regular payments were missed and the loan defaulted.  I'm not sure I would take it to that level but I do believe that is correct.

Ed Snyder

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Looking at this from an accounting point of view --> where was the check deposited? To regular the employer account such that they then paid each loan payment as they came or directly to the 401k plan/trust such that it was a lump sum? If to the 401k, how was the extra over time accounted for?  That might help decide the "pre" vs "extra" question.

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This situation comes up quite a bit.  The 72(p) rules are specific regarding requirements to be met for a loan to not be a distribution.  Level amortization is one item, as well as adhering to the plan/loan document.  That is, if a level amortization is required for payments to be at least quarterly, a plan would not be advised to contradict the terms of the loan and regulatory requirements to allow payments less frequent than quarterly in practice.  A written loan policy that attempted to define requirements outside of 72(p) would probably not meet IRS approval upon review.

Now, as indicated previously, a pre-payment if structured outside of the plan and posted as a plan loan payment to the plan each payment period would be OK for plan purposes.  However, a partial pre-payment in the plan can cause other issues regarding whether or not interest on future payment is reduced due to the excess payment.  An excess payment which reduces the net terms of the loan (other than proper full repayment), can be problematic unless the loan is re-amortized at the time of excess payment to continue payments in the original frequency as defined in the loan program.  If the prepayment is posted as a cumulative of several payments, at the interest amount due for each payment in the amortization schedule, would be interest at a rate greater than provided by the loan document and could violate the reasonable rate of interest.  I've seen many loan systems post multiple payments based on the amortization schedule as though made on the future dates and not as though paying a large principal payment all at once.

I'd caution treatment of a qualified retirement plan loan in the same manner as a retail loan as the rules in qualified plans are much more stringent.

ERPA

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improper for several aspects of the 72(p) regulations.  Improper in loan terms if charging future interest amounts on the single sum payment (i.e., not a reasonable and higher than stated rate of interest on the loan amortization schedule).  Improper in loan terms if allowing the single payment to reduce principal amounts so the level amortization schedule no longer applies.  May be proper if it could be re-amortized or refinanced under the document to show the change in principal and new amortization necessary for the life of the loan.

ERPA

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I don't do plan administration, and may have missed some formal or informal guidance on this, but let me try to put it plainly. Suppose a completely compliant loan calls for quarterly payments of $1,000, which fully amortizes over 5 years, with reasonable interest. The plan doc and/or loan policy has typical loan provisions that don't really address minutiae of accounting for loan payments, but meet requirements of regs. Participant comes in on or about March 31 and says, "Hey, please accept this check for $4,000 and that will take care of me for entire calendar year." Plan accepts and does exactly that, i.e., treats as payment for full year.

While I will readily admit that the above could cause admin system complexities and/or (more likely in my experience) errors, in a large plan, I do not see how it would create a distribution under 72(p). (If it is contrary to something in the 72(p) regs, I'm sure someone will point it out; I have not checked.) If the participant in question is already at the 415(c) limit, it could possibly cause a 415(c) violation under the IRS's general authority under 415(c) to treat something as a contribution based on facts and circumstances. The 415(c) issue could be dealt with, obviously, by recomputing the payments and either taking less than the full $4,000 or shaving payments and/or part of a payment off the back end of the loan.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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The disposition of a loan during the term is all about administration. The loan must be administered in accordance with its terms (including any permitted modification or replacement) and the terms of the plan, which includes the loan policy if the plan has a  compliant written policy separate from plan terms).

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aye, and there's the rub...  Plan loan requirements are more restrictive than retail loans.  As noted, if considered a contribution, the plan would be required to allow after-tax contributions or risk being disqualified.  And, even if the plan allowed after-tax contributions, there would need to be an existing election to contribute the amount and it may be required to have been based on payroll deduction.

ERPA

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