WHY IS GETTING A 401(K) LOAN ON THE RISE?
The concept of borrowing from a 401(k) account is nothing new. However, now that millennials (individuals aged 19-35) represent the majority of the American workforce, and are further away from reaching retirement, the concept of borrowing from a retirement plan is on the rise. According to a study by Ameriprise Financial, 17% of millennials have borrowed from their employer-sponsored retirement plan. What does that mean for plan sponsors?
Fiduciary duty means that plan sponsors are required to act in the best interest of plan participants. Since more than one-fifth of all 401(k) plan participants eligible for loans have loans outstanding at any given time, and most workers have very little saved after 20 plus years of work, it may be best to discourage employees from taking out a 401(k) loan.
DO I NEED TO OFFER MY EMPLOYEES THE OPTION TO GET A 401(K) LOAN?
Plans aren’t obligated to have a loan provision in their plan documents — although an estimated 87% of plan sponsors do. Since it isn’t mandatory, the easiest way to dissuade employees from borrowing from their 401(k) account would be not to offer the option in the first place. However, this could decrease retirement plan participation as new employees may not want to contribute if borrowing isn’t an option, and employees currently enrolled in the plan may contribute less.
ESTABLISHING GUIDELINES FOR OBTAINING A 401(K) LOAN
A good alternative can be to offer loans, but only allow participants to use them for emergency needs or substantial long-term purchases. 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 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 that would qualify for the casualty deduction.
Plans can use these same criteria — or any others — when defining loan purposes in their plan document.
DEFINING BORROWING LIMITS
Although ERISA gives plans the freedom to establish their own loan purpose criteria, it prescribes the maximum dollar amount of plan loans as the lesser of $50,000 or 50% of the participant’s vested plan assets.
In addition to setting a maximum, 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 wasn’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.
EXPLAINING THE PROS AND CONS OF A 401(K) LOAN TO EMPLOYEES
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. Sponsors should also explain the potential drawbacks of taking out a 401(k) loan, such as:
- Impeding the ability to save. The loan payments will reduce cash 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.
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.
IMPORTANT! Remember that plan sponsors and administrators need to properly document approved participant plan loans to prevent the loan from being treated as a taxable distribution.
Need help understanding what should be outlined in the loan documentation or if your current plan documents are meeting compliance standards? Feel free to reach out to Bill Cannon, the Director of Retirement Services at Glass Jacobson Financial Group.
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