401k Participant Loan repayments greater than the loan schedule.

[ScottCPFA]

I ran across what I think is an issue with a recordkeeper. I have several plans as a TPA that submitt payroll deducted 401k loan repayments. The employees model loans from the recordkeeper custodian site. Loans are granted by filling out a paper form that is submitted to the recordkeeper along with a loan amoritization schedule generated from their site.  

Employees in one plan receive bonuses and pay off loans early or increase their weekly 401k loan payment deductions to pay off the loan earlier.

The recordkeeping company has new software for applying loan payments. It applies the current payment on the schedule and if there is an amount in excess of that payment the exess is applied to the next full interest and principal payment, if less than a full payment the excess is applied to future interest on the schedule only rather than principal. 

It has been so long since I have done a deep dive into participant loan repayment details but it seems to me that violates some type of rule. It appears to me that you can't pay interest on a loan that is not due or has not accrued. I think you would run into a situation where the actual interest rate on the loan,  based on loan interest payments,  was greater than the schedule if you then paid it off early. 

I also think this would cause an issue administrating accrued loan interest if a loan defaulted, what interest would accure if you already made future interest payments. 

There also might be a potential for some type of discrimination if someone paid a loan off early about the same time frame on the schedule another employee paid larger payments on than shown on the schedule then paid off the remaining balance early specifically if in these 2 examples one employee was HC and another NHC. 

I may be off base or confusing some other regulation, but it would be logical to assume, even in a simple lending agreement,  you cannot apply a payment to interest in excess of the normal payment that is not acrued or in the future and not due as shown on the schedule that was used to establish the loan and the note. 

Scott 

[C. B. Zeller]

I have a feeling I know which recordkeeper you're talking about.

I agree completely, applying additional payments of principal to offset future interest is unsound. I don't think you'll find that rule in any IRS regulation; it is simply not how loans work.

If you are going to stay with this recordkeeper then you may want to modify the plan's loan policy to disallow repayment amounts other than the scheduled amount. A participant could request a re-amortization if they want to accelerate their payoff. Again, if I know which recordkeeper this is, then they have a function to request a payoff quote for an employee who wants to repay their loan in full; if the amount generated by the quote is deposited within a certain timeframe then it will correctly apply it to principal and treat the loan as fully repaid.

If allowing random repayment amounts is important to the plan sponsor, then they should find a new recordkeeper, as the current one does not meet the plan's requirements. They should let the recordkeeper know why they are leaving, if they choose this route.

[ScottCPFA]

Thank you for your reply.

My intial thoughts reminded me of an IRS or DOL ruling where a group of physicians took participant loans from the plan and made the notes for an interest rate of something high, like 30%, as a scheme to contribute more money in the plan. The rank and file employees with loans had normal interest rates. Predictibally the physicians were duly punished, but it also was the basis of current loan policies related to rates of interest being comencerate with a published or market determinable rate.  It was back in the 80's or 90's but I can't remember where I heard about that. My main concern is it cannot be logically explained to anyone, like the accounting firm doing the audit. To move the plans recordkeeper would also mean leaving the financial institution, which is doing a fabulous job. 

I was hoping to find some DOL, IRS or even some lending or banking regulation that would at least give more basis for something obviously faulty and probably driven by a lead programmer who is lacking. 

I appreciate your time.

Scott  

[Paul I]

@ScottCPFA there was a time when the loan interest on loan repayments to the plan was tax deductible (as was credit card interest paid and various other interest payments).  For the most part, the only interest repayment that has remained even partly deductible is mortgage interest.

If the current situation is a bur under your saddle, it would be a relatively simple calculation on a spreadsheet to show that the interest repayments are artificially high.  The agency who most likely would be responsive to you would be the DOL since they would view it as a prohibited transaction.

Good luck!

[ScottCPFA]

Thank you Paul, "prohibited transaction" may be the treatment for my "bur'.

Scott