Like many practitioners, we continue to monitor developments
under the new Administration on various aspects of employment and
benefit law matters, including the future of health care reform and
the Department of Labor's fiduciary rule. While the new
Administration develops its policies, we thought that we would
revisit some familiar topics in this month's newsletter.
With the decline in defined benefit pension plans, the
responsibility for saving for retirement and "building a
retirement nest egg" has been placed squarely on individual
employees. Despite this fact, most employers are concerned about
the adequacy of retirement savings – whether it be
paternalistic (which is often true based on our experience) or
business reasons (i.e. ensuring that "older workers have
enough and can afford to retire to make room for younger, less
expensive workers" as suggested by the Wall Street Journal).
Whatever the motivation, saving for retirement is important and
studies show that "leakage" (the term for using
retirement savings early for purposes other than retirement) is
significantly affecting the amount of savings available at
retirement. There are typically three channels for leakage:
in-service withdrawals (hardship or at age 59 ˝), cash-outs
at job separation and plan loans. This article will focus on 401(k)
Loan features are common in 401(k) plans. The Center for
Retirement Research at Boston College reports that about 90% of
401(k) plan participants have access to a loan feature and the
Employee Benefits Research Institute estimates that 20% of
participants have outstanding loans. Typically, loans are available
for any purpose (that is, they are not limited to hardship). The
right to borrow from the plan, on the other hand, is not unlimited.
By law, plan loans are limited to 50% of a participant's
account balance (unless the account balance is less than $10,000,
in which case a participant can borrow 100% of his or her account
balance) up to a maximum of $50,000 and plan loans must be repaid
in five years, except if the loan is for a down payment on a
Because plan loans are easy to obtain, have no up-front costs
and payments are made through payroll deductions, they are an
attractive option to participants. However, there are also
downsides. If the participant leaves his or her employment or is
terminated, the loan is accelerated and must be repaid. If the
participant does not have sufficient financial resources and the
loan is not repaid, it will be considered a
"distribution" and taxed at ordinary income rates, plus
10% penalty for early withdrawal, if the participant has not
attained age 59 ˝. Unlike a home equity loan, the interest
on a plan loan is not tax-deductible, which effectively increases
the cost of borrowing. Also, the interest paid on a plan loan is
effectively taxed twice – once, at the time the participant
earns the money to pay the interest on the loan, which is deposited
into the participant's account and again, at the time of
withdrawal. Finally, studies have shown that plan loans, even if
repaid on a timely basis, reduce the amount of savings available at
The decision to borrow from a plan is solely that of the
participant. In some cases, it may be the best or only course of
action available. Whatever the case may be, if you want to
encourage participants to maximize their retirement security
through retirement savings, or if you believe that the loan feature
is being over-utilized, there are steps you can take as an employer
and plan sponsor.
The first and the most important step is education. We recommend
that employers work with their 401(k) vendors to develop programs
to educate participants on the pros and cons of plan loans and
their impact on retirement savings. Traditional education and other
tools may be available to put the participant in the best position
to evaluate whether to borrow from the plan or not. Second, as a
plan sponsor, you are in control of the plan design and loan
feature. Although we do not recommend eliminating the loan feature
altogether, as a plan sponsor you can consider, among other things,
limiting the number of loans and the frequency of borrowing, as
well as re-borrowing (for example by imposing a minimum time period
between loan payoff and the issuance of a new loan). Another option
is limiting the sources from which a participant may borrow.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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