How does an employee’s military leave affect 401(k) loan repayments?

When 401(k) plan participants are called to active duty, they often request to suspend their 401(k) plan loan repayments during their military leaves. Many employers may wonder whether the rules for suspending loan repayments during a military leave differ from those applicable to a regular leave of absence. Indeed, they do.

Basic rules

The rules for suspending loan repayments during a military leave of absence are broader and more flexible than for a regular leave of absence. For a regular leave, the maximum suspension period is one year and the entire loan must be repaid within the maximum permissible term (five years, for non–principal residence loans).

For a military leave, your 401(k) plan may permit suspension of loan repayments for the entire leave period even if it exceeds one year. Also, you may extend the loan term to the maximum permissible term plus the period of military leave. Interest on the outstanding loan would continue to accrue during the military leave suspension period.

For example, say James took out a three-year loan on February 1, 2019, and is called to active military service for two years, beginning on October 11, 2019. Your plan can suspend his loan repayments during his entire two-year military leave. If he hadn’t been on military leave, his last loan repayment would have been due on January 31, 2022. But, because he’ll be on military leave, the term of the loan may be extended to its maximum permissible term (five years, if the loan is a non–principal residence loan) plus his period of military leave (two years). With this extension, his last loan repayment would be due on January 31, 2026.

Additional info

When a participant returns from military service, loan repayments must resume in substantially level payments. Because interest continues to accrue during military leave, the participant’s postleave loan balance will be greater than the preleave balance. The plan may permit the participant to either:

• Resume paying the same dollar amount as before with a “balloon” payment of the balance due at the end of the loan term, or
• Reamortize the balance due over the remaining loan term with payment amounts not less than those required under the original loan.

Also note that the Servicemembers Civil Relief Act (SCRA) provides that the interest rate on 401(k) plan loans (and other loans) during a period of military service cannot be more than 6% per year. The law imposes a criminal penalty for knowing violations of the interest-rate limit. Although the SCRA requires servicemembers to give the plan notice of their service orders, plan sponsors may want to consider imposing the 6% interest limit on any outstanding plan loan of a servicemember on military leave to avoid criminal penalties.

Valuable resource

Although 401(k) loans aren’t an ideal way for participants to deal with financial needs, many people still look to them as a valuable resource. Contact us for help navigating the rules for military leave and other types of leave.

Patrick Hoffert, CPA, Partner © 2019