September 2007 Pension Plan tip of the month...

Loans from a Qualified Plan: The Pros and Cons

Many Qualified Retirement Plans offer loans and this feature is often popular with participants. Often this feature can influence an employee in their 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.
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.

Pro: No credit check. If the applicant has a vested balance and doesn't have other loans outstanding, they will most likely be approved for the loan. Please refer to your individual Plan Loan provisions.
Con: There is no credit check because the participant is borrowing their own money. While the loan is outstanding, it is not invested in the market earning market-rate returns. The interest rate paid on a plan loan is often less than the rate the plan funds would have otherwise earned while invested.

Pro: The turnaround time 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 there is a proportionately larger “hit” to 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 is often lower than can be obtained elsewhere, and it 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. Since loan payments are paid with after-tax money, and then taxed upon distribution, the participant is taxed twice on the same dollars.

Pro: I f the 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 the participant should terminate employment and cannot repay their loan in full, any unpaid loan balance will be distributed to them as income. The amount will then be subject to income tax and may also be subject to 10% withdrawal penalty. A loan balance cannot be continued within an IRA or most new employer sponsored plans.

Pro: Loan Payments are deducted right out of the particpant's paycheck.
Con: Once the loan has been made, payments will be deducted from each paycheck, and generally cannot be stopped except for specific reasons such as military leave or a leave of absence.

Pro: The loan can be repaid in full at any time without penalties.
Con: There may be fees involved. Most plans charge a loan set-up fee. The loan may also be subject to a yearly service fee.

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 psychology of retirement saving. If possible, a participant's balance should 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.