To Borrow or Not to Borrow from a 401k Plan? That is a tough question by Michael Bourne
When a company is setting up a new retirement savings plan, one of the plan design questions that causes the most quandaries is whether to allow participant loans from the 401(k) or 403(b) plan (or whether to allow participants to borrow from a 401k plan). Many plan sponsors ask what have most companies done and simply follow suit. However, what most companies have done in the past isn’t necessarily how your plan should be designed. There is no requirement that a retirement savings plan offer loans.
Why are you establishing the new plan?
If the primary motivation for offering a retirement savings plan is to help your employees prepare for a fulfilling retirement, then allowing participants to take loans from their 401(k) account will probably work against that motive. However, if the goal is to get as many employees as possible to at least save something while taking advantage of any match being offered, then allowing 401(k) loans might increase participation because the employees will feel they can access the money if needed.
What’s the harm? Isn’t taking a loan from my 401(k) like lending money to myself?
There are four key reasons why taking a 401(k) loan is not like switching money from one pocket to the other:
- No compounding. The principal (amount borrowed) is not benefitting from any compounded growth had the money been left in the plan. This effect worsens the longer the term of the loan.
- Lower rate of return. Most likely, the interest that participants pay to their own account in the form of loan payment is at a lower rate than what the rate of return could have been had the funds remained in invested in the plan.
- “Double taxation.” Loan payments are made with after-tax dollars. Assuming the participant is in a 20% tax bracket, it takes $120 of after-tax dollars to make a $100 loan payment. Then, those payments are taxed again when the participant takes distributions upon retirement. Of course, pre-tax contributions are taxed upon distribution, too, but at least they didn’t get taxed going in like loan payments will.
- Reduced deferrals. Unfortunately, many employees reduce their deferrals to help with the cash drain of loan payments, which only makes saving for a fulfilling retirement harder.
Also, if employment terminates while a loan is outstanding, it’s quite likely that the employee will have to pay off the loan in a very short timeframe or the loan will be deemed a distribution. This triggers a 10% tax penalty for those under age 59 ½, as well as ordinary income taxes on the deemed amount.
What if we want to give our employees the ability to decide for themselves?
Below are some best practices for plans that allow participant loans:
- Allow only one loan at a time. An analysis of 401(k) loans by Fidelity showed that about half of first-time 401(k) borrowers took additional loans. The first loan is a “gateway” to more loans.
- Set requirements for taking a loan. Down payment on a new home, large medical expenses, and educational costs are some examples of understandable needs for a 401(k) loan that might be hard to finance via conventional means. These requirements should be included in your plan document, which can be amended if they weren’t originally included.
- Loans can come only from the participant’s own wage deferrals. In other words, don’t allow profit sharing and matching funds from the employer be available for loans.
- Don’t make the loan process quick and easy. Loans shouldn’t be one click away. Requiring an in-person meeting with the plan’s financial advisor or plan administrator can be used to review the requirements for taking a loan, as well as the ramifications of not paying it off. This may help participants consider whether the loan is necessary.
All of these will deter first-time loans and slow down “serial borrowers” – those who take loans after loans for discretionary purchases or items/issues that could have been handled in a better long-term manner. Their retirement funds need to last a lifetime.
So, yes, loan provisions encourage employees to participate in the plan, but they can also harm your employees’ abilities to save for retirement. Consider both plusses and minuses when deciding whether to offer loans and then help your employees make good choices by having a properly structured loan program.
Mike Bourne is the managing partner for Atéssa Benefits, a TPA firm specializing in defined benefit (DB) plan administration and ERISA Compliance. He is also a partner in MB Actuarial Services, which provides outsourced services to over 700 DB plans for other TPA firms. Both firms are located in San Diego, CA. He is also a CPA and an MBA from the University of Chicago.