Understanding 401(k) Loans
The Tax Cuts and Jobs Act of 2017 (TCJA) made changes to 401(k) loan repayment options, which may 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 administered by CrossPlans, 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 CrossPlans generally works with Plan Sponsors to design a rate equal to prime rate plus 2%. CrossPlans will often set a minimum loan amount of $1,000 to discourage trivial usage and to avoid 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. It is important to note that the expanded loan limit under the CARES Act has sunset and is no longer available.
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 reveal that 54% of plans offering loans only offer one loan, 37% offer 2 loans, while 9% offering 3 or more outstanding loans. We encourage Plan Sponsors to limit the number of available loans to 1 or 2 to prevent habitual usage.
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 30 years. CrossPlans generally does not recommend ever-extending beyond a 10 or 15-year term, even for purchase of a primary residence.
Different from a taxable Hardship distribution, loans are not considered a taxable 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.
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.
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 that 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, can 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. These 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 everyday, non-emergency expenses.
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.
If you have any questions regarding 401(k) loans, contact us at Distributions@crossplans.com today.
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