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Make Employees Aware of the Hidden Costs of 401(k) Loans

August 4, 1999
Generally, the ability of employees to access funds in their 401(k) accounts prior to retirement is restricted. Employees are not able to withdraw funds from their accounts, even in the event of hardship, unless strict conditions are met. Accordingly, to evade these restrictions and encourage low-paid employees to participate in the plan, most 401(k) plans allow employees to take loans against their account balances. Without such an option, many employees would be reluctant to tie up funds that they may need to purchase a car, make a down payment on a home, or to pay for medical care or other large or unexpected expenses. However, plan loans contain hidden costs and pose retirement risks—risks about which employers and plan administrators may need to inform employees.

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.