As we have encountered difficult times due to the Covid-19 pandemic, many employees are considering taking a loan from their 401(k) plan account. Although this is tempting when you are short of cash to pay bills or meet other financial obligations, the employee will be putting themselves at long term risk when they reach retirement. The funds taken out may not be repaid and while they are outside the plan, they are not earning any investment income that accrues during that time period. As this is a current issue, many employees and Plan Sponsors are dealing with during these turbulent times, we wanted to revisit Plan loans in this week’s blog post.
Many 401(k) Plans offer the option to participants to initiate a loan against the amounts accumulated in their 401(k) Plan account. These loans must follow various regulatory requirements and any restrictions imposed by the Plan itself or the Loan Policy administered by the Plan Sponsor. Many participants don't understand these loan restrictions. We have listed some below. We recommend Plan Sponsors review these items with each participant during the loan request process to ensure there are no misunderstandings with the employee concerning the transaction.
- Some Plans do not allow additional contributions into the 401(k) Plan until the loan is fully paid off. Of course, this limits the additional funds going into the account along with the earnings on the investment during the time-frame of the loan. The 401(k) account is provided to help an employee save for retirement. Having extended periods without contributions reduces the overall effectiveness of this benefit. In addition, most contributions are made pre-tax. Limiting the contributions during the year increases the overall taxes that must be paid by the employee. Lastly, if contributions cannot be made and the Plan offers a Company match, the match amounts are also lost.
- Plans almost always charge fees to initiate a loan. Employees usually don't understand that these amounts will be added to the total amount of the loan. They should be encouraged to research the true cost of the amount borrowed, including interest and all applicable fees, and compare this to other available funding sources to ensure they are paying the lowest overall charge for the funds borrowed.
- Most plans require loan repayment through payroll deductions. This means a lower amount in the employee paycheck for the time of the loan. Employees should be encouraged to review their personal budgets to verify they can live within the reduced income after subtracting out the loan and interest repayment amounts.
- Recent studies indicate that 40% of retirement plan participants take advantage of loan offerings and approximately 10% default each year. Employees should understand that in most cases upon the termination of employment the full amount outstanding on the loan becomes due shortly after termination. If the amount due cannot be repaid within the time period stipulated, the amount becomes taxable to the employee and may also be subject to an additional 10% penalty. This can be a heavy financial burden to an employee already in a bad situation due to the loss of income from the loss of employment.
Plan Sponsors may want to discuss with the employee alternatives to taking out a loan such as:
- A home equity loan.
- Reviewing rates for a personal loan.
- Try to negotiate with creditors first before considering a 401(k) plan loan.
Retirement plans can be very complex. As an innovative firm Summit CPA specializes in 401(k) audits. We have the ability to offer assistance entirely off-site with little or no distraction to your daily office routine. We also offer flat-fee pricing so there are no surprises on your bill when the job is complete. For assistance contact our office at (866) 497-9761 to schedule an appointment.