Loan prepayment allowed?

[Lou S.]

A participant would like to prepay the remaining semi-monthly payments for the remainder of the year.  Assume 6 months (12 payments) being made in a lump sum right now to cover all payment from 7/15/19 - 12/31/19.

Assume the participant loan program allows for these ad hoc payments and sponsor is OK with it.  Is this acceptable from an IRS stand point or is it a violation of 72(p)?

I realize 72(p) requires level amortization with payments no less frequently than quarterly but this is essentially paying the payments before they are due not in arrears and will not extend the term of the loan just reduce the overall interest paid. But is this a form over substance thing where it can't be done?

If it was just prepaying the next quarter instead of the next 6 months would this be OK?

[CuseFan]

I don't think making a lump sum payment now gets them out of any future periodic payments. My mortgage allows me to make additional ad hoc payments but if I make the equivalent of six monthly payments that does not relieve me of the obligation to make my next six payments. I would think the loan program allowance is for additional ad hoc principal payments rather than consolidating 12 semi-monthly payments into one semi-annual payment (6 into one quarterly payment - although that may be OK under 72(p) - but you are essentially changing the term of the loan). I would also see what the note says.

[Mike Preston]

7 hours ago, Lou S. said:

A participant would like to prepay the remaining semi-monthly payments for the remainder of the year.  Assume 6 months (12 payments) being made in a lump sum right now to cover all payment from 7/15/19 - 12/31/19.

Assume the participant loan program allows for these ad hoc payments and sponsor is OK with it.  Is this acceptable from an IRS stand point or is it a violation of 72(p)?

I realize 72(p) requires level amortization with payments no less frequently than quarterly but this is essentially paying the payments before they are due not in arrears and will not extend the term of the loan just reduce the overall interest paid. But is this a form over substance thing where it can't be done?

If it was just prepaying the next quarter instead of the next 6 months would this be OK?

In what universe can this be a problem? 

[Mike Preston]

6 hours ago, CuseFan said:

I would also see what the note says.

That much I agree with. 

[Luke Bailey]

I will second Mike's comment. I do not recall there being anything in the loan regs or any other IRS guidance regarding the handling of prepayments, so this would be governed by the terms of the note or, if the note does not address, probably state law. Very often a note will state that prepayments go directly to principal and cancel out the number of payments totaling that much principal at the back end. The parties could agree to change the note terms.

[Pam Shoup]

There are two issues here.  First, does the plan's loan policy allow for it?  Second, can the recordkeeper handle it?  Most recordkeeping software is built to basically use an amort checkoff.  It does not matter when the loan payment comes in.  The payment is just checked off of a loan amort and the full interest is still applied, even though the payment comes in early.  Keep in mind though, the participant is still just making a lump sum payment on the loan, the normal loan payments will still be due.

[Mike Preston]

If I understand what was written, the participant loan's original amortization calls for the loan to be fully repaid at the end of the year.  In essence, the participant should be asking what the exact dollar amount is to pay off the loan in full.  I doubt it would be 6 months of unreduced payments.

[Lou S.]

The loan has about 2.5 years left on it. It's a small plan and the participant is the wife of one of the owners who also process the company deposits. All Participants have maxed out their 402(g) limit for 2019 so to avoid the administrative hassle of logging on every 2 weeks for the rest of the year to simply make her loan payment she wants to make one payment covering all the remaining semi-monthly pay periods in 2019 so it is one less thing she needs to worry about.

I personally don't think it should be a problem or complicated but IRS rules on 72(p) and the custodian seem to be giving us blow back and want to treat it as an additional principal payment that doesn't effect any other remaining payments.

[Bird]

I believe this boils down to a technicality - if the participant wants to pay all of her remaining 2019 payments at once, and NOT get interest credit for the early deposit, then it is equivalent to a series of payments that just happen to be made at one time, and no problem at all.  If the participant wants to ultimately reduce interest for making a prepayment, then it should be treated as a principal payment, and it does not eliminate the need for the regularly scheduled payments.  

Of course the custodian might have its own (made up) rules and whether you want to fight them or not becomes part of the equation.  I'm almost certain that American Funds Recordkeeper direct will treat a lump sum as a series of individual schedules payments, so if you went to the amort. schedule you'd see a Dec scheduled payment being made in July with no adjustment to interest.  

[QDROphile]

I disagree.  I think prepayment of the outstanding loan balance is acceptable (and probably must be allowed), but paying more than the outstanding balance (the sum of future payments as scheduled) is not acceptable.  The IRS will treat the amount in excess of the outstanding balance as an illegal contribution.  Look at it this way:  When the outstanding balance is paid, the amount of the payment will be invested and will start to have investment return.  The investment return (assume it to be positive for purposes of illustration) is not a contribution.  But if the plan accepts more than the balance (the difference between the sum of scheduled payments minus the balance), the account will receive not only the balance, but also an "earnings" amount that is in addition to the earnings that the balance, as now reinvested, will receive (plus earnings on those earnings).  Foul! 

[C. B. Zeller]

For those who say this should be allowed, does this permit a back-door method of making after-tax contributions?

For example, I take a 50,000 loan from the plan, amortized into monthly payments at 6.5% over the next 5 years. That is 60 payments of 978.31. The next day, I make a payment of 58,698.60, which I instruct the trustee to treat as pre-payment of the 60 installments and not a single payment of principal. Have I just made a contribution of 8,698.60 which is not subject to any limitations or testing?

One year + one day later, what is my highest outstanding loan balance in the last year for purposes of taking a new loan?

[jpod]

This is silly.  Unless there is something to the contrary in the loan documents, which is extremely unlikely, the participant must be allowed to pay off the loan in full early by repaying the outstanding principal balance plus interest accrued to date.  If some service provider has to jump through some hoops too bad.  

[C. B. Zeller]

25 minutes ago, jpod said:

the participant must be allowed to pay off the loan in full early by repaying the outstanding principal balance plus interest accrued to date.

That's not the question though. The question is, on a loan schedule with N payments of X remaining, can a participant pre-pay the next M (<N) payments by making a single payment of M*X and then make no further payments until they resume regular payments of X after M pay periods?

[QDROphile]

The loan payment schedule is usually a level payment amortization, so the sum of the scheduled loan payments is potentially much greater than the principal balance plus the unpaid actual accrued interest to the date of payment.  I would not get too excited about the prepayment of interest through the end of the month of prepayment (meaning that the scheduled payment for the month* can be included in the prepayment) rather than calculating to the actual prepayment date.  The unpaid principal balance has to be calculated and separated because it is included in the remaining payments along with the scheduled interest component of each scheduled payment.

*I would have to think about a quarter for a quarterly amortization schedule. 

[jpod]

14 minutes ago, C. B. Zeller said:

That's not the question though. The question is, on a loan schedule with N payments of X remaining, can a participant pre-pay the next M (<N) payments by making a single payment of M*X and then make no further payments until they resume regular payments of X after M pay periods?

Ok, my bad.  My answer is the same unless the plan and/or loan documents don't permit partial repayment.    

[Bird]

On 7/10/2019 at 3:09 PM, C. B. Zeller said:

For those who say this should be allowed, does this permit a back-door method of making after-tax contributions?

i guess if you want to call them something I'd call them "extra" contributions...

On 7/10/2019 at 3:09 PM, C. B. Zeller said:

For example, I take a 50,000 loan from the plan, amortized into monthly payments at 6.5% over the next 5 years. That is 60 payments of 978.31. The next day, I make a payment of 58,698.60, which I instruct the trustee to treat as pre-payment of the 60 installments and not a single payment of principal. Have I just made a contribution of 8,698.60 which is not subject to any limitations or testing?

But you just put after-tax money into a plan and turned it into taxable money when it comes out.  I don't see how there is an advantage to that.  Just to clarify, I was being very specific that pre-paying, say, 15 payments at once and/but treating them as 15 separate payments on the amortization schedule would be ok, and (to the original point), no payments would be due until the date the last of the prepayments was originally due had passed.  

[Mike Preston]

Allowing a participant to pay or pre-pay more than the amount necessary to extinguish a loan is ...............?  Options: unwise, unfair, fiduciary failure, theft, other?

[QDROphile]

Possibly a loan failure, which would be a prohibited transaction,

Certainly an improper  contribution, which is a disqualifying event.

[C. B. Zeller]

14 hours ago, Bird said:

But you just put after-tax money into a plan and turned it into taxable money when it comes out.  I don't see how there is an advantage to that.

What if the loan was taken from a Roth source?

[Bird]

2 hours ago, C. B. Zeller said:

What if the loan was taken from a Roth source?

Mmm, ok, I'll give you that one as an advantage.  This conversation is largely angels dancing on the head of a pin for me - I think I'd allow someone to pre-pay as discussed through the end of the current quarter and maybe year but would definitely...maybe/probably (?) not allow it beyond that.  Will let you know the next time it happens...

[RatherBeGolfing]

My issue with this is that the participant wants to prepay  loan payments rather than make a prepayment on the loan itself.  It might sound like a distinction without a difference but it seems like it should matter...

Most loan programs I have looked at allow for prepayment.  some only allow for full prepayment, but most allow for full and partial prepayment.  But prepayment usually means that you pay off the loan earlier than the original maturity date of the loan.  Basically its applied on the back end of the loan.

In this instance, the participant wants to make a prepayment, keep the original maturity date, but skip the next 5 payments.  While I haven't seen a policy that actually allows for that situation, I don't think I have seen one that specifically prohibits it either.  If a change to the policy is made, or an interpretation of the existing policy made,  I don't think im comfortable skipping the regularly scheduled payments and just applying the pre payment.

Maybe if there was a good reason for it, like someone is going on leave or having surgery or dealing with a sick relative for a period time... 

 

 

 

[AKconsult]

Most loan policies have language to this effect:

"A Participant loan must provide for level amortization with payments to be made not less frequently
than quarterly."

I don't see anything in the loan policy used by our document provider that specifically discusses the timing of each loan payment, that is nothing that says that a participant couldn't pay the next 12 payments in 1 lump sum and then not have to start paying again until January, 2020.  Think about it this way - if your mortgage payment is due on the 10th of each month, when can you make that payment?  Is it ok to make it on the 5th?  Is it OK to make it on the 25th of the previous month?  Sure it is.  If you send in a payment on the 25th of May for the June payment, and then send in another payment on the June 5th , the lender is probably just going to apply that 2nd payment to July, so you are basically "ahead".

So if the loan payment is $150 per pay period, I don't see anything that would prevent someone from paying $1,800 and having it applied to the next 12 payments on the amortization schedule.  I think the only issue will be determining what the custodian can/can't do.  Lou has already indicated that in my example the custodian would want to apply the $1,800 as a one-time principal payment, though, so that does not accomplish what the participant wants.  So I think unless the custodian is able/willing to handle the $1,800 as 12 separate $150 payments, this is a no-go.