401(k) Loans: Friend or Foe?

by Crystal Ekanayake and Elisa Stodghill

Both the advantages and drawbacks should be carefully considered.

Whether or not to offer participant loans in a retirement plan is a question every plan sponsor must consider. Offering loans may encourage more employees to participate in the plan by giving them the assurance that they will be able to access their money if they need it. On the other hand, participants who withdraw funds for loans may hinder their ability to save enough for retirement.

Determine what you want to achieve with your plan
As a plan sponsor, you should begin by evaluating your motives for offering a retirement plan. If your goal is to provide an avenue for your employees to save for retirement, 401(k) loans may work against your objective. Because employees have access to their money, they can take away from their retirement savings for current needs. On the other hand, if your goal is to have as many employees participate in your plan as possible, giving them the assurance that they will be able to access their money can help attract employees that otherwise may not have participated.

Borrowing from the retirement plan
Consider whether employees are likely to understand the loan process and the tax consequences of borrowing against their retirement account. Loans can have severe financial consequences if the worker terminates employment while a balance is still outstanding. In most instances, participants will have limited time to repay the entire outstanding balance, or risk defaulting on the loan. In the case of a default, the loan is deemed to be a distribution, and the participant will receive a Form 1099 for the outstanding loan amount. This results in taxable income to the participant.

Staffing to support a loan program
Providing a loan program may result in “hidden costs” in the form of increased administrative burden for your human resources and payroll departments, as well as increased fees from the plan's service providers. While some of these costs may be charged directly to the participants who are taking loans, others may be bundled in the recordkeeping fees charged to the plan sponsor.

Advantages to offering participant loans

  • Studies have shown there are higher participation rates for plans that have loans as a plan feature.
  • Loans provide flexibility for participants to access credit they might not have otherwise had.
  • Interest rates on 401(k) loans are less than the APR charged by nearly every major credit card.
  • Participant loans do not get reported to credit agencies, so they have no detrimental effects on a participant's credit rating.
  • Participant loans have no application, late payment or appraisal fees, making them less costly to obtain than other sources of debt (such as a home equity loan).

Drawbacks to offering participant loans

  • Participants who continually take loans will miss out on the future earnings of their investment balances, and the interest rate charged on the loan may be lower than the actual earnings the account would have earned in the market.
  • Participants may treat the plan as a bank account. They may contribute money to the plan, only to repeatedly take it out in the form of a loan for non-emergency reasons, such as vacations and gifts.
  • Most service providers charge increased recordkeeping fees for the costs associated with administering loans. Fees may also increase for your annual ERISA audit.
  • The plan sponsor must monitor and take corrective action on loans that are in danger of default. If the plan's loan provisions are not followed, the plan may be at risk of operational failure and potential disqualification.

Best practices when offering a participant loan program

  • To ease the recordkeeping burden, limit the number of outstanding loans at one time, or limit the number of outstanding loans per participant.
  • Establish parameters for taking a loan and include these written restrictions into the plan’s loan policy or plan document. Employees may be required to show proof that the loan will meet their need. Examples for acceptable loan usage could be for the purchase of a primary residence, medical expenses, funeral costs or education costs for the participant's beneficiary or dependent.
  • Place restrictions on what account balance sources can be used to take a loan. If desired, employer sources (e.g., profit sharing and employee match funds) can be excluded, such that the only available loan funds stem from the participant's own salary deferrals.
  • Require that participants meet with the plan's financial advisor or plan administrator prior to loan approval, rather than letting participants request loans in an online "one-click" format. An in-person or telephone meeting can be used to discuss why the participant is requesting the loan, the repayment schedule and the ramifications of not paying it off. A loan counseling program may help participants consider whether the loan is necessary given their financial situation.

Alternatives to loans
If giving employees access to their money while employed is a priority for your organization, you can choose to implement a hardship distribution program. A hardship distribution allows participants to withdraw money while still employed, subject to the following IRS guidelines:

  • The employee must provide proof of the need, and the distribution amount requested cannot exceed the need. The IRS stipulates specific acceptable conditions of need for hardship distributions.
  • The employee will need to stop contributing to the plan for six months after the hardship distribution.

Hardship distributions must be treated with care, as the employer must obtain evidence of the hardship from the employee and review the documentation to ensure it meets the guidelines set forth by the IRS. Documentation should be maintained for compliance and audit purposes.

Ultimately, loans and hardship distributions are not required features of a plan; it is up to your organization to decide whether you want to offer these features. iBi

Kyle Rose is the local contact for CliftonLarsonAllen; contact him at kyle.rose@CLAconnect.com or (309) 495-8716. This article was originally published on CLAconnect.com. The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen). For more information, visit CLAconnect.com.