APRIL 2009 Pension Plan tip of the month...
Loans from a Qualified Plan: The Pros and Cons
Retirement is an important phase of one’s life and, because we are living longer, healthier lives, we can expect to spend more time in retirement. Experts say at least 70% of pre-retirement income will be needed to maintain the same standard of living. Therefore, it is very important for participants to maximize the amount available for retirement.
Many qualified retirement plans offer loans, and this feature is often popular with participants. Sometimes, this feature can even influence an employee’s decision to join the Plan. Having a loan option available through the Plan can make some employees rest easier about deferring part of their hard earned pay.
However, during these times of economic uncertainty, more and more participants are requesting loans from their retirement account. If permitted by a plan’s document, a loan enables a participant to borrow up to 50% of the vested balance with a minimum of not more than $1,000 and a maximum of $50,000. In most cases, when a participant borrows from his or her account, the loan must be repaid within 5 years with repayments made through payroll deductions. The specific terms of the loan - interest rate charged, the money types available, the “reasons” a participant can request a loan, whether or not an extended repayment period is permitted for home loans, the number of loans a participant can have outstanding - are determined by the Plan Sponsor and are outlined in the Loan Program and Administrative Procedures. Despite these limitations and restrictions, a recent survey has shown that approximately 20% of plan participants have outstanding loans.
There are many factors to consider when looking into taking a retirement plan loan, both positive and negative. It is important to remember the purpose of a 401k plan is to fund retirement, and not to treat it as a checking account. Employers can help to avoid potential abuse of a loan feature and promote retirement savings by educating their employees about the potential risks of loans.
Pro: The turnaround time from the time the Plan Sponsor approves the loan application until the time the participant receives the check is usually within 2 weeks, which can be useful in an emergency situation.
Con: Unlike deferrals, loan payments are made with after-tax dollars, so the participant has less take-home pay. If the participant decides to reduce deferrals in order to pay back the loan, the participant’s investment will fall even further behind -- and still further if any applicable match is missed.
Pro: The interest rate, while required to be reasonable, is often slightly lower than can be obtained elsewhere, and the interest paid back goes right into the participant’s retirement account.
Con: Loan interest isn't tax-deductible, because it is paid to the participant. In fact, it is considered earnings for tax purposes during retirement.
Pro: Interest rates have dropped in recent months, making refinancing options more attractive. Depending on your Plan’s service provider and document provisions, it may be possible for participants to refinance their loans to a lower interest rate, withdraw additional funds or increase the term.
Con: Adding an additional amount to an existing loan balance by refinancing may make the participant’s financial situation more difficult, as, in many cases, the loan payment amount will increase. Make sure that refinancing or initiating a new loan is the best choice for each participant long term.
Pro: If a participant defaults on a 401(k) loan, the default will not be reported to the credit-reporting agencies and it will not negatively impact their credit rating.
Con: If repayments are stopped for any reason (besides certain leaves of absence, where a loan suspension could occur for up to a year), the loan will default at the end of the quarter following the quarter in which the payments ceased. Any unpaid loan balance at that time will be deemed a distribution to the participant and treated as taxable income. The amount is subject to income tax and may also be subject to 10% early withdrawal penalty if the participant is under the age of 59.5. Loan repayments cannot be continued within an IRA and, in many cases, the new employer-sponsored plan does not accept transfers of plan loans. If the participant is still employed with the company, and the Plan only allows for one loan, the participant will not be eligible to take another loan until the original defaulted loan plus interest is paid back.
Pro: The loan can be repaid in full at any time without penalties.
Con: There may be fees involved in obtaining and maintaining a plan loan. Most service providers charge a loan set-up fee. The loan may also be subject to a yearly service fee. These fees are typically passed along to the participant.
Pro: The process is usually simple. Some plans require an application to be printed and returned; others only require a phone call.
Con: Some Plan Sponsors find the additional payroll work required with participant loans time consuming.
Finally, a loan affects the philosophy of retirement saving. If possible, a participant's account balance should sit untouched until retirement. It can be too easy for employees to get in the habit of dipping into their retirement plan instead of saving for things they need. This reduces the amount the participant will have available for retirement and may even cause the participant to have to work longer. Reducing an account balance by taking a loan impacts the benefit of tax free growth on earnings that is available in retirement plans, impacting a participant’s ability to accrue the amount needed for a secure retirement.