Curbing Enthusiasm for 401(k) Plan Loans

Here are some friendly tips for employers when considering the loan provisions available in the 401(k) Plan they offer to their employees.  Enjoy!

 

SITUATION:

We allow our employees to borrow against their 401(k) plan account balances. We understand that the ability to take out a loan can reassure employees that they have access to their account assets if they need them and can increase plan participation and contribution rates. However, we have to spend time and money administering the loans. And we’re concerned our employees may be hurting their chances for a comfortable retirement by borrowing too much and too often.

 

QUESTION:

Other than not offering loans, what can we do to discourage employees from taking unnecessary plan loans?

 

ANSWER:

You can take a number of actions to limit plan loans, including educating employees about the pitfalls of plan loans and placing restrictions on loans.

 

DISCUSSION:

Eliminating plan loans entirely might hurt plan participation.  Instead, to discourage employees from taking plan loans they may not really need, provide information about both the advantages

and disadvantages of borrowing from a 401(k) plan account. While employees may already know about the ease and convenience of plan loans, they might not be aware that:

 

• Loan repayments are made with after-tax money.

• Taxes will be paid again when the money is distributed from the plan.

• It can be difficult to continue to save for retirement and pay back a loan.

• If they leave employment, loans generally must be repaid at that time.

• If a loan isn’t repaid, the outstanding balance would be treated as a taxable withdrawal subject to both income tax and a possible 10% early withdrawal penalty.

Before processing a loan request, provide employees with a summary of the potential disadvantages of a plan loan.  Other actions you can take to discourage excessive loans include:

 

• Limiting the number of outstanding loans an employee can have at one time.

• Limiting the number of loans an employee can take in a 12-month period.

• Restricting borrowing to only money that the employee has contributed.

• Increasing the loan origination fee.

To potentially reduce the number of loan defaults, arrange for repayment to be made through payroll deductions or automatic checking account deductions.