Can i pay my 401k loan off early

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.

If your plan allows loan payoffs to be processed online, select Initiate a payoff or early payment in Loans and withdrawals. If you already have the maximum number of outstanding loans allowed by your plan, you won't be able to process a new loan until repayment of a prior loan is completed.

Your plan's loan payoff provisions can be found under Access my money in Plan Rules.

Note: These links will require you to log in if you have not done so already.

If you're heading to a new job and still owe money on a 401(k) plan loan from your former employer's retirement savings plan, be sure you know what will happen to that outstanding balance.

While you may be permitted to continue paying off the loan in installments, most companies expect immediate repayment when you leave. And if you don't fork over what's owed, it can result in an unexpected tax bill.

"Typically, if you have a loan and leave your job, you're supposed to pay back the loan within a short time period," said certified financial planner Avani Ramnani, managing director for Francis Financial in New York. "If you don't, it's considered a distribution with tax [consequences]."

Last year, roughly 13% of 401(k) participants had a loan outstanding, according to Vanguard's How America Saves 2022 report, which was released Tuesday. While largely unchanged from 2020, the share is down from 16% in 2016.

The average balance on those loans is $10,614 and is most common among workers with incomes from $30,000 to $100,000. About 81% of plans allow loans, whose repayment terms typically are five years.

Also, 401(k) loan use is highest among participants age 45 to 54, at 18%, Vanguard's report shows. That's followed by 15% in the 35-to-44 age cohort and 13% for those 55 to 64.

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Federal law allows workers to borrow up to 50% of their account balance, with a maximum of $50,000. (In 2020, that cap was temporarily increased to $100,000 for loans initiated due to Covid-related reasons.) 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, when you leave your job — whether by choice or not — the tax treatment can change.

As mentioned, if your plan requires you to repay the money right away and you don't, your account balance will be reduced by the amount owed. This so-called "loan offset" is considered a distribution subject to ordinary income taxes and potentially the 10% early-withdrawal penalty.

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Yet if you can come up with what you owe, you can essentially roll over the loan offset amount to an individual retirement account or another eligible plan and avoid the tax consequences.

You get until the federal tax deadline the following year to do so — i.e., if you leave your job in June 2022, you generally would get until April 18, 2023, to come up with the funds for the rollover (although if you file a tax extension, you'd get longer).

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