Suffering the Slings and Arrows of 401(k) Loans
To loan, or not to loan, that is the question. And there's no easy answer. Whether to let participants borrow from their 401(k) accounts is one of the many decisions a plan sponsor must make when designing retirement plan benefits that are in the best interest of employees.
A Rock and a Hard Spot Decision
The truth is, no matter what you decide, the choice will never make all employees happy.
If you do not make loans available in your plan – It's only a matter of time before one or more employees approach you with very legitimate liquidity needs. Someone's experienced a family medical emergency or bereavement expense and is in an immediate and unavoidable financial pickle. You want to help them through the crisis, but your hands are tied.
If you make loans available – There will likely be times when employees stage ill-advised raids on their retirement accounts. Like the grasshopper in Aesop's fable, they may borrow money for a vacation, a brand new car, or a home that is beyond their means. This defeats their own best interests as well as your retirement plan's essential purpose of helping them achieve a comfortable retirement.
Thus, in making the decision to offer or not offer loans, plan sponsors must carefully consider their employee demographics. Are your employees financially secure and sophisticated and likely to apply for a loan only in an emergency? Or will they be like the employees of one sponsor I met, whose 100-participant plan has 70 participants with loans? In this case, the participants figured out that they could contribute, capture the employer match, then borrow back their participant contribution.
Genius? No, not really. Not on the participants' part and not on the sponsor's part for allowing the practice. For participants and sponsors alike, the decision is a balancing act calling for clear assessment of near- and long-term financial needs.
A 401(k) Loan Overview
Step one in assessing whether to offer 401(k) loans in your plan is understanding your options. Let's review some 401(k) loan basics.
- The maximum loan amount per statute is $50,000 or half of the participant's vested account balance, whichever is less.
- The minimum loan amount is frequently set by the sponsor at $1,000.
- The maximum loan term is five years, except for loans for buying a personal residence, which can have a term of up to 30 years.
- Loans are repaid with each paycheck or, upon termination, as a lump sum within a set period.
- Loan prepayments are allowed.
- Interest is charged on the loan, with a fixed rate set at initiation of the loan. A common rate selected by sponsors is Prime rate plus 1%.
- A sponsor may decline a participant's request for a loan. For example, it would be in your employee's best interest for you to deny the loan if you knew that they would not be with the company for much longer, or if they were in the middle of a divorce and facing an imminent Qualified Domestic Relations Order (QDRO).
For reasons described above, you may decide to allow 401(k) plan loans, while doing all you can to encourage responsible borrowing for legitimate needs. On that front, you can:
Limit lending to hardships only – You can add a hardship provision to your lending requirements, limiting the reason loans can be taken to imminent threats such as unreimbursed medical costs or imminent eviction.
Create your own list of allowable loan reasons – Limiting loans to a finite set of reasons will help you make objective decisions and reduce employee raids on their account. But creating your own list adds administrative burden. The reasoning must be applied on a uniform and non-discriminatory basis and a documented decision-making process must be in place.
Limit lending to one loan at a time (and refinancing) – To best straddle a fine line between supporting financial hardship and enabling financial foolishness, we suggest prohibiting participants from taking out more than one loan at a time. If they can't manage their finances after the first loan, chances are they'll be even less likely to recover from two or more. A related consideration is whether to allow refinancing on existing loans. On one hand, the ability to refinance allows the participant to circumvent the 5-year repayment rule. On the other hand it gives some flexibility to the participant who is hit with a second unexpected financial hardship before the loan is repaid.
Develop a strong employee education program – As we've described in our best practice post, "Financial Education for Your Plan Participants," you're acting as a good steward for your company plan by helping participants understand how their 401(k) plan fits into their bigger financial picture – including responsible borrowing. That makes employee education an investment well worth making for everyone concerned.
In helping participants objectively assess a potential loan, following are a few of the questions worth considering (preferably, if available, in alliance with a professional advisor):
Opportunity costs – How much appreciation could be missed while the funds are out of the market? In theory, missed market appreciation during the loan term could be a multiple of the cost of loan alternatives such as an auto loan or home equity loan.
Tax ramifications – Interest paid goes into the participant's plan account, which sounds like a good thing on the face of it. But it also means the interest is taxed twice as regular income. First, it's paid with after-tax dollars. Then it's taxed again when it's distributed from the 401(k) account in retirement. Ouch. Clearly, these are not loans to be taken lightly.
Employment status – It's important to objectively assess how likely it is they will remain an employee. If they leave before the loan is fully repaid (whether voluntarily or not), the loan is immediately due. Any unpaid balance becomes income subject to ordinary Federal and state income taxes, plus a 10% penalty if the participant is under age 59-1/2.
The Benefit of Administrative Support
If you do decide to offer loans, seek administrative support. To make your own life a lot easier, work with a recordkeeper who can automate the loan process on your participant web site. Participants can then sign up for loans themselves; the recordkeeper will determine the maximum loan and per-paycheck repayment amounts. When the participant selects the amount and terms, you receive a summary e-mail to review. If the loan is authorized, the recordkeeper will disburse the check. They then track repayments and warn the sponsor when the final loan payment differs from the prior.
The Loan Decision is Meaningful
So again: To loan, or not to loan? Employee loans are among the major causes of "leakage" from 401(k) plans, which is the inelegant term that the 401(k) service industry uses to describe funds that leave plans prior to participant retirement. In a perfect world, your plan would be airtight, with nary a drop lost. But we live in a world of uncertainty. Your decision to loan or not to loan could have a meaningful impact on whether your employees are able to enjoy the standard of living they envision for their retirement. It's a decision that deserves careful consideration.
Do you like what you've read so far? We also offer a complimentary presentation to further explore these best practices with you and other key retirement-plan decision-makers at your company. Please contact us to learn more.