According to the Employee Benefit Research Institute, more than one-fifth (or 21%) of all 401(k) plan participants eligible for loans have loans outstanding at any given time. Looking out for the best interests of your plan participants might involve discouraging them from borrowing against their savings, at least in the absence of a personal financial crisis.
Offering loans
For starters, plans aren’t obligated to have a loan provision in their plan documents — although an estimated 87% of plan sponsors do. So the definitive way to discourage loans would be to amend your plan and no longer offer them. However, this may backfire for two reasons: It may stop employees from joining the plan and current plan members may not continue to contribute because of the inability to access their retirement funds in a perceived emergency.
Alternatively, plans can offer loans, but limit them to specific, nonfrivolous purposes. For example, ERISA allows for hardship withdrawals using the following safe-harbor definition of hardship:
- All deductible medical expenses incurred or anticipated to be incurred by the employee, the employee’s spouse or dependent,
- Purchase (excluding mortgage payments) of an employee’s principal residence,
- Tuition and related educational fees for the next 12 months for postsecondary education for the employee, spouse, children or dependents,
- Payment to prevent eviction from the employee’s primary residence or foreclosure on the mortgage on the employee’s primary residence,
- Funeral expenses of parents, spouse, children or dependents, and
- Certain expenses relating to the repair of damage to the employee’s principal residence that would qualify for the casualty deduction.
Plans can use these same criteria — or any others — when defining loan purposes in their plan document.
Borrowing limits
Although ERISA gives plans the freedom to establish their own loan purpose criteria, it prescribes the maximum dollar amount of plan loans. Specifically, participants may borrow the lesser of $50,000 or 50% of the participant’s vested plan assets.
Plans can create an exception to the 50% limit for loans up to $10,000. However, some plans may choose to require a separate security for this loan type. If the participant previously took out another loan, the $50,000 limit is lowered by the highest outstanding loan balance during the one-year period ending on the day before the new loan.
Plans can also set a minimum loan amount, to discourage borrowing simply to cover routine expenses. Doing this may also reduce the plan’s administrative expenses related to plan loans.
Prior to 2010, plan loans were covered by the Truth in Lending Act (the federal law mandating disclosure of a variety of loan facts). One such required disclosure included the total amount of interest the borrower would pay if the loan weren’t paid off until the end of its term. Plan sponsors can still provide this information so that prospective borrowers understand the loan’s total cost.
Communicating with participants
When talking with participants about plan loans, sponsors should do more than just ensure that the purpose of the loans meets the plan document requirements. Each participant should understand the pros and the cons of borrowing against plan assets. For example, explain to participants that plan loans may result in:
- Impeding the ability to save. The loan payments will reduce cash otherwise available for retirement saving.
- Forfeiting potential investment gains. When plan investments are performing reasonably well, dollars used for loan repayment won’t be earning those returns on a favorable tax-deferred basis.
- Taxing inefficiency. Loan payments are made with after-tax dollars, and when these payments are taken from the plan on distribution, they are taxed again.
- Putting retirement capital at risk. If a participant defaults on the loan, the collateral—the participant’s remaining retirement savings in the plan — will be liquidated to repay the loan. Also, the IRS considers the liquidated savings a distribution. That means the amount of the forced distribution is subject to income tax — and, if the participant is under age 59½, the IRS also assesses a 10% premature withdrawal penalty.
- Limiting job mobility. If the borrower changes jobs, he or she might be required to repay the balance within a relatively short period of time. If the participant can’t raise the cash to pay it off, it’ll be considered a default, and the participant will lose retirement savings and be subject to tax consequences.
- Going backward financially. The point of having a retirement plan is to prepare for retirement. Using it to add more debt defeats its purpose.
Making the decision
In certain circumstances plan loans can be a good choice. However, they’re not always cost effective — for both the participant and the plan. Be sure to discuss the pros and cons of plan loans with your participants.
Plan loan documentation: Not a casual affair
Plan sponsors and administrators need to properly document approved participant plan loans to prevent the loan from being treated as a taxable distribution. For example, the loan must be a legally enforceable agreement. Make sure the loan document, whether on paper or electronic, is dated, states the loan amount and binds the participant to a repayment schedule.
In addition, the plan loan documentation must:
- Secure the loan with the borrower’s account balance,
- Provide an interest rate and repayment schedule similar to what a participant would receive from a financial institution,
- Base payments on a level, amortizing schedule payable no less frequently than quarterly, and
- Require repayment of the loan within five years, unless the participant uses the loan to purchase a principal residence.