Employees taking loans form their defined contribution (DC) plan like a 401k or 403b is never ideal but most plans offer them for fear that people won’t join the plan unless they have access to their money. There are best practices in offering loans, which can get out of hand, but there are also myths about them as reviewed by Morningstar.
Best practices on loans include:
- One loan at a time
- Six month waiting period between loans
- Loans based only on hardship which are verified and administered by the plan’s record keeper
- Default insurance for those involuntarily separated which is why most loans default
- Required online counseling like with student loans
So what are the myths about loans?
- Loans Never Make Sense – To pay for critical needs and under hardship criteria, loans can make sense. Plus, interest is paid back to the employee themselves. DC loans might be better than raiding a Roth IRA where repayment is not required.
- Loans are a Wash to Pay Off High Interest Debt – Interest payments on DC loans are usually less than, for example, credit card rates plus the interest is paid to the employee. No doubt that participant loses appreciation during bull markets.
- Taxes are Paid Twice – Taxes are only paid on the money used to pay back the interest not the principal repayment.
- Job Loss Creates a Crisis – People may be unable to pay back their loan when they lose their job but some companies have longer payback periods and others are providing insurance which pays off the loan in the event of involuntary separation.
Love them or hate them, loans are a reality and likely necessary for most companies that don’t have an employee emergency fund but be sure to use best practices and debunk the myths.
