Employee Benefit Views

Is your 401(k) loan program state-of-the-art?

Posted August 13, 2013 by Robert C. Lawton at 11:38AM. Comments (6)

Do you have a 401(k) loan program? What trends have you seen? Share your thoughts in the comments. —Andrea Davis, Managing Editor

A significant component of retirement readiness is protecting participants from themselves. Many recent studies have shown that major obstacles to employee attainment of retirement readiness include the loss of account balances due to loan defaults and hardship withdrawals. This account leakage can be reduced by a well-managed participant loan program. A state-of-the-art loan program has the following characteristics:

Loans are limited to safe harbor hardship withdrawal criteria

Plan loans are horrible investments. The cost is high (due to double taxation), interest payments are not deductible and penalties may apply if the loan is defaulted. Rather than allowing employees to borrow to buy a boat, snowmobile or deluxe vacation, many employers have chosen to limit participant loans to hardship withdrawal criteria. This allows employers to qualify (and essentially limit) plan loans using well-accepted legal criteria. Valid hardship withdrawal requests are for funds to: prevent eviction or foreclosure; pay medical or funeral expenses; purchase or repair a primary residence; and pay educational tuition.

Participants are allowed to take only one loan at a time

Participants who take more than one loan have been found to default more often on their loans. Defaults can occur when a participant moves on to another job or loses a job and is unable to continue making loan payments. Some participants also take as many loans as possible if it appears that they may be facing a layoff or moving on to a different employer, as a way of advancing a distribution from the plan.

Referral to the company EAP is mandatory for all loan applicants

If safe harbor hardship withdrawal criteria are used to determine loan eligibility, it only makes sense to refer potential borrowers to the employee assistance program for financial counseling. Keep in mind that the retirement plan may be the lender of last resort for these employees, many of whom aren't able to qualify for a loan from a financial institution. Requiring financial counseling before the loan is made may help the employee avoid a hardship withdrawal, where the funds permanently leave the retirement plan.

Tighter participant loan programs are becoming commonplace at companies committed to retirement readiness. Plan sponsors who have successfully migrated to more stringent loan programs have done so as a result of effective participant education sessions, which outline the retirement readiness concept in detail.

Robert C. Lawton is president of Lawton Retirement Plan Consultants, LLC, a Registered Investment Advisory firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He can be reached at bob@lawtonrpc.com or 414.828.4015.


Posted by: Helen P | January 3, 2014 11:49 PM

In spite of 401(k) loans making good financial sense in theory, the quantity of 401(k) loan defaults is still higher than normal. A number of people have trouble paying them back once they take from their retirement funds. Take a peek at personalmoneynetwork.com

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Posted by: Jack T | August 19, 2013 7:44 AM

I very much agree with the four prior comments, but would go a step further and rewrite the article to confirm just what is state of the art in 401(k) loans - I will send it to Employee Benefits and we will see if they publish it.

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Posted by: Lawrence S | August 19, 2013 7:19 AM

Professionals writing articles for professionals or plan sponsors should not be making such fundamental errors as the patently incorrect statement about loans being "double taxed". Simply put, there is no "double taxation" involved. The typical "double taxation" nonsense is that you are paying the loan back with after tax money and then, when you take out the benefit, you are again paying taxes on the money. NONSENSE. When you took the loan, you did NOT pay taxes on the distribution; it is THAT money that is going back in. When the ultimate distribution is taken, the taxes are due on money that has NEVER BEEN TAXED BEFORE (money that went in on a tax deductible basis as either employee deferral or employer contribution). I agree that loans are bad, but the reasons they are bad must be accurately stated; once you make a mistake like this, people are not apt to listen to the other things you have to say. Anyone who wants a copy of my Journal of Pension Benefits article on loans (Borrowing From Peter to Pay Paul) may email me at larrystar@qpc-inc.com with your email address and I will be happy to forward the article.

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Posted by: KIMBERLY S | August 15, 2013 5:04 PM

Taking a loan from the plan and repaying it puts the plan account back in exactly the same position is was at the start. It was, and remains pre-tax money.Taking a loan from the plan requires repayment. If it is repaid with salary, that would be post tax. If it is repaid from a gift or life insurance proceeds, that has probably not been taxed. Regardless, the participant repaying the loan is in exactly the same tax position whether the repayment is made to the plan or to a bank or credit card company. There is no "extra" tax paid by taking the loan from the plan.

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Posted by: Chris R | August 15, 2013 2:18 PM

It seems to me that, when a distribution from a 401(k) plan occurs, there is double taxation when there had been a loan with payments made, at any time in the past. Can you explain where my thinking is not correct?

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Posted by: Chris F | August 14, 2013 9:19 AM

There are a number of issues with this article. 1. 401(k)loans are not double taxed. 2. Loans are not always a bad investment. They are certainly better than stable value funds and money markets under the right conditions. 3. Limiting access to 401(k) assets via loans will be a barrier to entry for some participants. 4. The single biggest issue with loans is the risk of default. If a plan wants to be "state-of-the-art", it should allow separated participants to continue repaying outstanding loans. 5. The one issue with loans that can't easily be solved through plan design is that participants sometimes stop contributing after they take a loan. The bottom line is that as long as participants continue contributing at the same level and do not default on the loan, it is not that damaging to retirement. In fact, if the market is going down while the loan is repaid, the participant will benefit from the loan.

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