Retirement plan loans can be both an opportunity and a burden to participants. Loans come with the risk of default and penalties—which can have significant impact on the borrower. However, through smart retirement plan design, participant education, and knowledge of recent legislation, plan sponsors can help to minimize loan usage—and defaults.
Weighing the Benefits of Loans
It is generally not advisable for a participant to take a loan from a 401(k) retirement plan because it can reduce the long-term growth of a person’s retirement assets. But for many plan participants, the ability to take out a loan is seen as a positive, giving them peace of mind that they could have access to their money if they really needed it.
Indeed for some employees, plan loans may be a vital source of funds when there are no other options to meet a compelling financial need, like the purchase of a home. Retirement plan loans frequently have low interest rates and repayments are essentially made back to one’s self, rather than a financial institution, which can add to their appeal.
Significant Risks to Borrowers
An obvious risk of a plan loan is that a borrower’s employment may end with an outstanding loan, escalating the chance of default. The consequences of default are considerable for the participant. Plan loans generally become due upon termination of employment. An outstanding loan balance that is not repaid is treated as a taxable distribution and may also result in an additional 10 percent early withdrawal penalty if the participant is under age 59 ½.
The Tax Cuts and Jobs Act, which became law in 2017, allows more time for a participant to roll over an outstanding loan balance to an individual retirement account (IRA) or another employer’s qualified plan and avoid immediate taxation. The plan participant has until the due date for his or her individual federal income tax return (including extensions) to come up with the funds to complete a rollover of the outstanding loan balance. This provision is intended to decrease the likelihood of default for departing employees, helping them keep more of their money invested for retirement.
Tips for Designing Lower-Risk Retirement Plans
- Review and Assess Loan Activity: An annual review of your plan loan activity (e.g., rate of new loans, number of loans per participant, and default rates) will help you ascertain whether plan loan usage is trending toward becoming a problem.
- Consider Your Plan Design: Building in additional plan rules can help plan sponsors minimize loans and their accompanying risks.
- Think about limiting the number of loans allowed to encourage judicious behavior among participants. The ability to take out multiple loans can increase the rate of plan loans.
- Consider building in certain loan restrictions (e.g., excluding company contributions from available funds or limiting loans to hardship reasons only).
- You may want to provide terminated employees with the ability to repay outstanding loans under the same schedule as active employees, to encourage full repayment.
- Educate Your Participants: The more employees understand the consequences of unpaid loans—and what happens if employment is terminated with an outstanding loan—the more likely they’ll be to borrow responsibly or seek better funding options.