401(k) Loan Policy Best Practices
To start, here’s a bit of general background on 401(k) loans policy:
Despite the fact that adopting a liberal 401(k) loan policy can add administrative burden, the majority of plan sponsors do. According to the Employee Benefits Research Institute, virtually all (around 90%) of larger plans–those with more than 1,000 participants–offer the feature. It is also common in smaller and mid-sized plans. Among plans with 51-100 participants, 75% offer loans, while the figure dips slightly to 68% for those with 25-50 participants. Even 30% of the country’s tiniest plans with under 25 employees allow 401(k) loans. As you can see, the standard trend across the industry is that larger plans are more likely to allow employees to borrow against their retirement savings.
How common is borrowing against a 401(k) balance, anyway?
According to the same research, 18% of 401(k) participants held a loan balance in 2015, with an average loan balance of $7,982. The percentage of participants with a balance is skewed down by the youngest and oldest participants who are least likely to borrow against their retirement savings. About 24% of participants in their 40s held a loan balance, for instance, and that figure has been more or less constant over the past 20 years. While the industry unsurprisingly saw a huge surge in borrowing during the financial crisis, the percentage of borrowers has ticked lower since.
Why offer 401(k) loans?
Saving for retirement may seem like an almost theoretical concept for workers in the 20s and 30s. So diverting money toward an account with no way to access those funds for decades may be too big a leap for some. But knowing that their savings could be accessed in an emergency may make the idea of saving for retirement a bit easier. In fact, the ability to borrow may actually encourage reluctant employees to participate in the company plan, and even prod them to defer a larger portion of their salary into the 401(k). Some even argue that borrowing the down payment for a home from the 401(k) can make financial sense, particularly if the loan allows the borrower to avoid paying private mortgage insurance.
What are the restrictions on 401(k) loans?
If you are considering making loans available through the company 401(k), there are a few restrictions. The IRS limits the loan amount to $50,000 or 50% of the participant’s vested account balance – whichever is less. So an employee with a $40,000 401(k) balance could borrow no more than $20,000.
Participant loans must be repaid within five years. However, if the borrowed funds will be used for purchasing a principal residence, the term may be longer. Repayments must be scheduled in substantially equal amounts that include principal and interest, and must be made at least quarterly.
It’s up to the plan sponsor to determine if participants may take out more than one loan at a time. However, IRS rules require that if a second loan is secured, the amount of the new loan plus the outstanding balance of the existing loan must remain within the IRS limits mentioned above.
Plan sponsors have lots of flexibility when it comes to structuring 401(k) loans. The plan sponsor can set its own loan limits and repayment schedules (subject to IRS rules), and even limit loans to specific purposes. But the plan must specify the procedures for applying for a loan along with the terms for repayment.
What can go wrong with 401(k) loans?
The obvious drawback to borrowing from the 401(k) is that fewer dollars are available in the account to compound investment returns. And once borrowers begin repaying a loan, either through payroll deduction or automatic debit to a bank account, they may feel too financially squeezed to continue making contributions to the 401(k). A borrower who fails to make contributions for 2, 3 or 5 years can dramatically reduce the assets available at retirement, which is obviously doesn’t bode well for your employees’ long-term financial wellness.
An inability to repay a 401(k) loan can put the participant even further behind when it comes to building a retirement nest egg. Failing to repay a 401(k) loan results in a default, and is treated as a distribution. That distribution is taxable income, and if the employer is younger than 59 ½, a 10% early withdrawal penalty is imposed.
An employee changing jobs may be surprised to learn that their loan must be paid in full. While such a policy is not required, most plans stipulate that a 401(k) loan must be repaid once the employee leaves. Often the employee’s only recourse is to default. That’s means the remaining balance becomes a taxable distribution which comes with the early withdrawal penalty.
When considering your plan’s loan policies, you will want to make sure that access to loans can provide your employees flexibility without providing incentives to make poor financial decisions. For example, a 2014 Wharton study found that if employees were allowed to take on multiple loans against their 401(k) balance there were more likely to borrow. Employees may perceive generous loan policies as endorsing 401(k) borrowing rather than as an alternative to traditional financing sources in the event of an emergency.
7 Best Practices for your 401(k) loan policy
Plans sponsors who want to provide the flexibility of 401(k) loans while helping their employees avoid savings setbacks can start with good plan design and education. A good loan program encourages employees to think carefully before borrowing against their retirement savings, and may even provide disincentives to such borrowing. Here are seven tips for a successful loan program, recommended by the International Foundation of Employee Benefit Plans.
- Educate employees about the implications of a loan: For example, make sure borrowers understand the consequences of changing jobs with an outstanding loan balance.
- Implement service fees: Research indicates that origination fees are associated with smaller loan balances. A service of $50 or $100 won’t derail a sound financial decision but could make an employee think twice before making an unnecessary transaction.
- Don’t appear to advocate borrowing: Avoid lax lending policies that may encourage borrowing. For example, don’t allow borrowing against employer contributions, and limit acceptable reasons for taking out a loan.
- Discourage savings interruptions: Encourage employee contributions to continue over the course of the loan. Here are some tips to do so!
- Make repayment easy: Provide repayment flexibility. Consider not calling the loan once an employee leaves, but rather allow for direct debit from a bank account in the wake of a job change.
- Don’t rule out loans altogether: Borrowing from a retirement account may never be an ideal situation, but offering such flexibility may keep employees away from high interest and fee-heavy lenders. A low-cost borrowing alternative can be a boon to employees in an emergency.
- Consider limiting loans to specific purposes. Consider requiring that loans must be used for emergencies or hardships (however defined) and home purchase down payments.