Educating Participants About the Dangers of Taking Out a 401(k) Loan

It is critical for plan sponsors and advisers to educate participants about the consequences of taking out a loan, Julie Stich, associate vice president of content at the International Foundation of Employee Benefit Plans tells PLANADVISER. “They need to keep the money in their plan to build up money over time through contributions and the compounding of investment returns,” Stich says.

Citing data from the National Bureau of Economic Research, Stich says more than one-fifth, 21%, of participants have an outstanding loan, and within a five-year period, that rises to 37%. The employer will charge participants interest on the loan, which is typically the prime rate plus 1%, she notes. Furthermore, 86% of borrowers leave their company with an outstanding loan, and most companies require participants to repay the loan before leaving, she says. If that is the case, the Internal Revenue Service (IRS) will consider that a distribution and subject the balance to taxes plus a 10% early distribution tax, Stich says. And these loans can be sizeable, since the IRS permits participants to borrow up to 50% of their balance or $50,000, whichever is less, she notes.

Stich recently authored a blog on the International Foundation of Employee Benefit Plan’s website about how sponsors can limit loans, titled, “Top Five Tips for 401(k) Loan Program Design.” In it, she says sponsors should explain the consequences of changing jobs with a loan outstanding. Sponsors should also only permit participants to take out one loan at a time. Stich also suggests that sponsors limit loan access to only employee contributions, not company matches, as well as the dollar amount or percent of vested balance available.

“Sponsors can also limit the reasons why a participant would take out a loan, such as for debt reduction or to pay for the child’s education,” Stich says, although the IRS does allow participants to take out loans for the purchase of a primary residence. The IRS also permits participants to take out hardship withdrawals if they are for certain reasons, including medical expenses, to avoid being evicted from their home, to pay for funeral expenses or to repair damage to their primary residence, she says.

Most sponsors charge service fees, she notes. “The higher the loan origination fee, the lower the balance,” she says. “The most common service charge is $50, followed by $75.”

Finally, sponsors can permit participants to continue to contribute to their 401(k) while they are repaying the loan, and they can set up repayment from a personal bank account rather than payroll deductions so that when an employee changes jobs with an outstanding loan, they can continue to repay the loan and avoid defaulting on it and face steep taxes, she says.