Retirement Plan Loans: The Pros and Cons

Offering Loans

Firstly, 401(k) plans aren’t obligated to offer loans. However, an estimated 87% of plan sponsors do offer loans. The easiest way to discourage participants from taking loans would be to amend the plan to no longer offer loans. Doing this may result in unintended consequences, such as employees choosing not to participate in the plan, and current plan members not contributing to the plan due to inaccessibility to their retirement funds in a perceived emergency.

As an alternative measure, plans can limit loans to hardship withdrawals, where the participant must prove that the loan is taken for a specific purpose. ERISA allows for such hardship withdrawals if a participant is paying for the following:

  • 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 define hardship loan purposes using the above, or any other criterion in their plan document.

Borrowing Limits

ERISA allows plans to establish their own loan purpose criteria as discussed above. However, it does prescribe a maximum dollar amount for plan loans. Participants are limited to borrowing the lower of $50,000 or 50% of their vested plan assets.

Plans can provide for an exception to the 50% limit for loans up to $10,000. However, the plan document may require a separate security for this loan type. If the participant already has another loan outstanding, the limit is $50,000, less the amount of their highest outstanding loan balance during the one-year period ending on the day before the new loan.

Some plans set a minimum loan amount to discourage borrowing to cover routine, non-emergency expenses. This provision can also result in reducing the plan’s administrative expenses related to plan loans.

Plan loans, prior to 2010, were covered by the Truth in Lending Act (a federal law requiring disclosure of certain loan facts). One of the required disclosures was the total amount of interest the borrower had to pay in the event that the loan was not paid off until the end of its term. Plan sponsors can choose to provide this information so that a participant deciding on whether to take out a loan understands the true total loan cost.

Communicating with Participants

When discussing loans with plan participants, sponsors should do more than simply ensure that the purpose of the loan is in accordance with the plan document requirements. Each participant should understand the advantages and disadvantages of borrowing against their retirement plan accounts. For instance, sponsors should explain to participants the following possible consequences of taking a loan:

Reduced Ability to Save. The loan repayments will reduce cash otherwise available for retirement savings.

Forgoing Potential Investment Earnings. When plan investments are performing well, dollars used for loan repayment will not be earning those returns on a favorable tax-deferred basis.

Tax Implications. Loan repayments are made with after-tax dollars, so as a result, these payments are taxed again when taken from the plan on distribution.

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 liquidated savings is considered by the IRS as a distribution. This means the amount of the forced distribution is subject to income tax. Additionally, if the participant is under the age of 59½,  a 10% premature withdrawal penalty is assessed.

Limiting Job Mobility. If the borrower is planning to change jobs, he or she may be required to repay the balance within a short period of time. If the participant is unable to raise the funds to pay it off, it is considered to be a default. As a result, the participant will lose their retirement savings and be subject to tax.

Increased Debt. The purpose of retirement savings is to have money for retirement. Using the plan to add debt defeats that purpose.

Making the Decision

Taking a plan loan may be a sound decision in certain circumstances. However, as discussed above, there are many factors to be considered by both the participant and the plan sponsors. Plan sponsors should communicate the pros and cons of plan loans with participants.

 

Sidebar: Plan Loan Documentation Requirements

Plan sponsors and administrators, in order to prevent a plan loan from being treated as a taxable distribution, should maintain proper documentation. For example, the loan must be a legally enforceable agreement. The loan document, whether it’s on paper or electronic, should be dated, state the loan amount and bind the participant to a repayment schedule.

In addition, the plan loan documentation must:

  • Secure the loan with the borrower’s account balance,
  • State the interest rate and provide a repayment schedule similar to what a participant would receive from a financial institution,
  • Base payments on a level, amortizing schedule payable on at least a quarterly frequency, and
  • Require repayment of the loan within five years, unless the loan is for the purchase of the participant’s principal residence.

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