JULY 2008 Pension Plan tip of the month...

Retirement Savings and the Impact of Participant Loans

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 try not to access money from 401(k) accounts in order to maximize the amount available for retirement.However, during these times of economic uncertainty, more and more participants seem to be requesting loans from their retirement plans. 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 $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 generally 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’s Loan Procedures.

There are many negatives a participant should consider before applying for a 401(k) loan. If the participant terminates employment with an outstanding loan balance, the loan needs to be repaid in full.  If not repaid, the loan becomes a distributable event and will be taxable on the participant’s tax return with a 10% penalty tax if the participant is under age 59½. This additional tax burden generally comes at a time when the participant cannot afford to pay it.  Often, participants decrease the amount they are contributing to the plan in order to repay the loan, which impacts the ongoing growth of the participant’s account and , if the participant is contributing on a pre-tax basis, reduces the tax shelter advantage of participant contributions on take home pay.  The participant could also miss out on the employer matching contribution.  Earnings are impacted since there is less money to invest and loan initiation and on-going processing fees further reduce the account balance when deducted from the participant’s account. This

snow ball effect diminishes long-term savings and the overall value of the participant’s 401(k) account.

Not all plans allow for loans and many allow them only for hardship reasons. Despite these limitations and restrictions, a recent survey has shown that approximately 20% of plan participants have outstanding loans.

What can employers do to avoid potential abuse of a loan feature and promote retirement savings?  First, limit participants to one loan at a time.  Institute a waiting period between loans, i.e., cannot request a new loan for 6 months after paying off the current loan.  Consider limiting the reasons that participants can request loans.  Educate employees about the potential risks of loans.