Now more than ever it seems like participants are inquiring about their plan’s loan options. A study from the Employee Benefit Research Institute found more than one-fifth (or 21%) of all 401(k) plan participants eligible for loans have loans outstanding at any given time. Although it may seem like a good idea to borrow from one’s account, Plan Sponsors may want to take a deeper look into whether or not plan loans are in the best interest of the participants.
One common misconception is that all 401(K) and profit-sharing plans offer loans. It is imperative that the Plan Sponsor read the plan document to see if the plan they have set up can even offer loans. The truth is plans are not obligated to have a loan provision in their plan documents — although an estimated 87% of plan sponsors do. The definitive way to discourage loans would be to amend your plan and no longer offer them. However, this may backfire for two reasons: 1) It may deter employees from joining the plan altogether and 2) 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, non-frivolous purposes. For example, ERISA allows for hardship withdrawals using the following safe-harbor definition of hardship:
- All deductible medical expenses incurred or those 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 post-secondary 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 would qualify for the casualty deduction.
Plans can use these same criteria (or any others) when defining loan purposes in their plan document.
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 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 was not 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
Being proactive and educating the plan participants on the effects of taking a loan out can certainly help them make a better decision. 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 will not be earning those returns on a favorable tax-deferred basis.
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 cannot raise the cash to pay it off, it will 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 are 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.
Sidebar: 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.
For more information on retirement plan loans, contact Jim Pellino at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.