Loan programs are subject to restrictions.
Before adopting a loan program, the employer needs to aware of several restrictions. Generally:
- the loan terms must be set forth in a written and legally enforceable agreement;
- the amount of the loan may not exceed the lesser of $50,000 (reduced by previous outstanding loans) or one-half of the present value of the participant's vested benefit;
- the terms of the loan (other than principal residence loans) must require repayment within five years; and
- the loan must be amortized on a substantially level basis with payments made no less frequently that quarterly.
The loan program must further meet several requirements designed to ensure that plan loans do not constitute prohibited transactions that may subject the employee and the employer to an excise tax.
Loans could adversely affect employee's retirement savings.
Employees need to realize that, although loans allow them to avoid the tax penalties typically imposed on in-service withdrawals from a 401(k) plan, plan loans are not without cost. Loans invite set-up costs, administrative expenses, and transaction fees that are typically deducted from a participant's account. In addition, although employees may think that they are borrowing money from themselves because the loan reduces their account balances, the loan is actually being made by the plan and thus must be repaid with interest, even if the employee terminates employment.
Even though federal law does not restrict the reasons employees take a loan from a 401(k) plan, the ease with which employees may access their accounts should not encourage employees to treat their account balances as checking accounts. There are serious potential adverse effects of such withdrawals on retirement savings. Specifically, because a participant's account balance must be partially liquidated in order to fund the loan, the income-generating impact of compound interest on the smaller account balance is reduced. As a result, even though the participant is repaying the loan with interest (generally the prime rate plus a stipulated percentage), the repayment terms may not be sufficient to match the lost growth caused by the reduced impact of compound interest on the smaller account balance.
Loan modeling informs participants of effects of loans on retirement savings.
Employers sponsoring 401(k) plans, in addition to restricting loans to a minimum amount (e.g. $1,000) or limiting loans to conditions of hardship, should consider fully informing employees of the effect a loan will have on their retirement savings. One way to do this is "loan modeling," in which the terms of the loan, including the amount of the loan, the repayment period, and repayment amounts, are factored into a projection of the impact of the loan on the employee's future account balance.
Cite: Code Sec. 72(p); IRS Proposed Reg. Sec. 1.72(p)-1; ERISA Reg. Sec. 2550.408b-1(b)(2).
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The information contained in this article is intended to provide useful information on the topic covered, but should not be construed as legal advice or a legal opinion.