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    Winter-2016  


An Employee Perk Can Be Trouble For Employer, Staff Member

For many plan sponsors the revolving door of 401(k) loans is an all-too-familiar issue. 

As technology has evolved it has made initiating a participant loan as easy as a few clicks of the mouse.

To the employee, the advantages are---no credit checks, I’m borrowing my own money and paying myself back the interest, no creditors calling me if I default…how bad could it really be?

According to PLANSPONSOR’s 2012 Defined Contribution survey results, which contained responses from 7,021 plan sponsors, 77% of defined contribution plans let participants to take loans from their retirement plan.  Of those plans, 16% of the employees have outstanding loans.

According to Adam J. Miloro, CFP®, AIF the opportunity cost of a 401(k) loan in many cases can be substantial even if you pay it back.  In addition, participants routinely run into a tax nightmare if they leave their employer while still having a loan balance.

Many participants need this money in a pinch and don’t take the time to realize the long-term ramifications of earnings lost by pulling this money out of their pre-tax account.  Consider someone who is 35 years old and wants to borrow $10,000 from their 401(k) and repay it over a 5-year period.  If this individual assumes a 7% rate of return on their investments and the loan interest rate is 4.25% (prime +1) this participant will lose $4,123 in retirement earnings even if they repay the loan on time.  To compound matters many participants either reduce their contributions or stop them all together in order to pay the loan back, further exacerbating the problem. 

This lack of forward thinking can rear its ugly head once again if participants don’t consider the ramifications of leaving their employer while still having an outstanding loan.  The Bureau of Labor Statistics reports that people born between 1957 and 1964 held an average of 11 jobs from ages 18 to 44, so this issue arises quite frequently.

Since loans typically are not transferrable to their new employer, the participant is faced with a difficult decision: either pay the loan off in full (usually within 30-60 days) or default on the remaining balance.  By this point the loan money is already spent and very few have the ability to pay off the remaining balance, so in reality it’s not much of a decision at all.  Back in 2009 the US Department of Labor estimated that 401(k) loan defaults were roughly $670 million a year and climbing. 

These defaults can drain retirement accounts above and beyond the original loan amounts.  Consider a 40-year-old employee who takes out a $15,000 401(k) loan and repays only $3,000 of it before voluntarily or involuntarily leaving their employer.  In this case the remaining $12,000 balance would be considered a premature withdrawal subject to federal tax, state tax and a 10% penalty.  For someone in the 25% percent bracket, the end result could be $3,600 federal tax bill, plus state tax.

Many participants justify taking a 401(k) loan since they would prefer to pay the interest on the loan to themselves then to some other financial institution.  We must remember that participants are paying these loans back with after-tax dollars, which means double taxation on the interest portion.  Consider the interest payments as a new contribution going into their accounts: again, these are funded with after-tax payments so the participant has already paid taxes once.  Fast forward 20 years and now the participant is getting ready to retire and take a distribution from his or her account. Now, these after-tax interest payments will then be subject to taxation again along with other pre-tax money.

Plan sponsors should consider some options to limit the amounts of loans while still offering them.

It Make sure to set up your plan so that it only allows one loan outstanding at a time.  Years ago, it was not uncommon for plans to allow participants to have two, three or even more outstanding loans.  This can create an administrative nightmare for human resources and can do significant damage in eroding participant’s retirement savings.  Once a participant takes out one loan he or she is more apt to dip into that well again in future.

Limiting participant loans for hardship reason only is another option.  Most plans today allow their participants to take a loan for any reason. However, plan sponsors have the ability to add in a hardship provision so that participants can only take a loan for a financial hardship that is “immediate and heavy.” 

Examples of hardship reasons include the purchase of a primary residence, unreimbursed medical expenses, the prevention of eviction from your primary residence, and college tuition for yourself or a dependent. This not only limits the reasons for taking the loan, but the employee also has to prove the severity of the financial hardship and will be limited to that amount if he or she qualifies.

A more creative step is for the plan sponsor to take the extra step of allowing participants to take out the maximum loan amount of 50% of their vested account balance up to a maximum of $50,000) for hardship reasons only.  The maximum loan is smaller for those who wish to borrow for a reason other than a financial hardship (assuming the plan document would allow such a provision).

The issue concerning 401(k) loans continues to be the lack of education surrounding them.  Yes, it is true there are certain situations where taking a loan from one’s retirement plan could make sense, but for many it signifies a much larger problem: livings beyond their means.

Let us not forget that the spirit of the 401(k) plan is to be used as a long-term saving and investing vehicle, not as your savings account for your trip to Cancun.

Adam J. Miloro, CFP®, AIF®  is a vice president of with Longfellow Advisors, a consulting firm in Boston that provides a wide range retirement plan services.  Miloro provides guidance to employers and employees, working with the latter in groups and one-on-one.  He can be reached at amiloro@lf-adv.com. 

 

 


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