Understanding 401(k) Loans
The recent enactment of the Tax Cuts and Jobs Act of 2017 (TCJA) makes changes to 401(k) loan repayment options, which should prompt plan sponsors and plan administrators to re-evaluate their existing loan program, processes and procedures. This article will provide an overview of the loan provision and offer a list of considerations that plan sponsors can use when adding or modifying an existing loan feature to their plan.
Although not required by law, many 401(k) plans offer a loan provision as a way for plan participants to access money prior to retirement. The thinking is that more employees will contribute to the plan if they know they can tap into their savings should they incur an unexpected expense while working; conversely, if employees can only access their savings at retirement, employees may decide not to contribute at all.
Rates & Loan Amounts
The loan rate is determined by the plan (i.e., the plan sponsor or plan fiduciaries) and is usually equal to prime rate plus 1%. Plans will often set a minimum loan amount of $1,000 due to the administrative work involved in processing them. The maximum loan amount is usually 50% of the participant’s vested account balance up to $50,000.
Special considerations are available for participants affected by certain natural disasters and it’s a best practice to check the IRS’ website for more information.
While loan rates and minimum loan amounts are fairly consistent across all plans, there is less commonality on the number of permitted outstanding loans. Recent findings from the PLANSPONSOR 2017 DC Survey: Plan Benchmarking reveal that 59% of plans offering loans only offer one loan, 31% offer 2 loans, while 9% offering 3 or more outstanding loans.
Offering plan participants the ability to have more than one outstanding loan may feel like a gratifying gesture on behalf of the employer. However, participants may view this as an endorsement by the plan sponsor to simply take a loan whenever money is needed.
The Pension Resource Council in 2014 revealed that participants who have access to multiple loans are more likely to borrow in the first place: “This is suggestive of a buffer-stock model also found among credit card borrowers. In other words, given the ability to borrow multiple times, workers are more willing to take the first loan, given that they retain slack borrowing capacity for future spending needs.”
Loan repayment schedules are set-up to include substantially equal periodic payments which include both principle and interest and must be repaid within 5 years. However, if the loan is for the purchase of a primary residence the plan may permit a lengthier repayment time period, such as 5 to 15 years.
Distribution of loan proceeds are not considered a distribution of plan assets and thus are not subject to taxation, unless the participant defaults on the loan. Plans have options in how they wish to treat defaulted loans. One common option is a “deemed distribution”. Upon a defaulted loan, the outstanding loan amount becomes a taxable distribution of plan assets, plus 10% tax-penalty if the participant is under age 59½.
Another option for handling a defaulted loan is a plan “offset”, where the participant’s account balance is reduced or offset by the unpaid portion of the loan. This offset amount is treated as a distribution of plan assets which is eligible for rollover. Until recently the participant would have up to 60-days to rollover the outstanding loan amount into an IRA or another eligible tax-qualified employer plan to avoid a taxable distribution. Effective January 1, 2018, the TCJA extends the usual 60-day time-period until the participant’s federal tax filing deadline, including extension, if the plan offset is due to the participant’s termination of service or an entire plan termination. Note: the 60-day rollover period still applies to actively employed participants who default on a loan while still working for the employer.
This is good news for participants as they now have a greater time period to affect a tax-free rollover of their outstanding loan offset, however, according to Drinker Biddle, a law firm specializing in employee benefits, “plan sponsors may wish to coordinate administration of their plan loan offset rollover rules with the plan’s third-party administrator (TPA) in order to avoid inadvertently ‘defaulting’ the participant’s plan loan.”
While a loan feature may help increase plan participation and be viewed as a positive outcome, participants taking loans are reducing their overall retirement savings. Here’s why:
- The loan amount reduces the overall 401(k) account balance where earnings can grow tax-deferred.
- The interest rate, while fairly low compared to other commercially available loan options, is usually less than a reasonable rate of investment return.
- Most plans will restrict a participant from actively contributing to the plan while repaying the loan.
- The loan principal and interest are repaid with after-tax money, but the participant will still pay taxes on those money upon distribution in retirement.
All of these items together are a recipe for hindering the advantages of tax-deferred savings inside a 401(k) plan.
Loan Program Considerations
If the purpose of a 401(k) plan is to help employees save for retirement, it may seem counterintuitive to offer a loan provision, which if utilized, will have a negative impact on the participant’s retirement nest egg. For plan sponsors who feel it’s important to offer access to these funds prior to retirement, here is a list of considerations to use when designing a loan program, which can help provide a fine balance between these two diametrical financial objectives.
From Plan Participant’s Perspective
- Educate Employees – Provide employees with information about taking a loan and the financial consequences for doing so—addressing default and repayment options for remaining actively employed versus changing jobs. If offering financial wellness programs, ensure this is a covered topic.
- Limit the number of loans to one – Allowing participants access to multiple loans may change the participant’s mindset that the plan is more like an ATM than a long-term savings vehicle.
- Increase the minimum loan amount – Increasing the minimum dollar amount that can be borrowed may discourage participants from taking loans out for every day, non-emergency expenses.
- Flexible Repayment Sources – Allow participants the option of having loan repayments debited from a banking account, rather than just their paycheck. This will make loan repayments easier for those employees who change jobs.
- Encourage Retirement Savings – Do not restrict participants with outstanding loan(s) from participating in the plan. Give them the choice to continue to make contributions to the plan, at the same time as making repayments.
From Plan Administrator’s Perspective
- Create a Loan Policy Statement – This will provide an overview of the plan’s loan program, inclusive of the number of outstanding loans permitted, including; interest rate, repayment time period for purchase of primary mortgage, and how defaulted loans are treated for actively employed employees vs terminated employees (i.e., “deemed distribution”, “offset”).
- Coordinate with TPA on the best way to administer new time-frame for “offset” distributions
- Update Summary Plan Description (SPD) – Ensure SPD has current information on the loan program, including time-frame updates for “offset” distributions.
- Qualified Disaster Amendment – If you have participants living in disaster areas, ensure that the plan has been properly amended to permit extended repayment periods for hurricanes and other disaster areas. These amendments generally need to be made no later than the end of the 1st plan year beginning on or after January 1, 2018.
- Verify the loan – Cybercrime is on the rise. Take the extra step to contact the account owner to verify they initiated the loan request.