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(Reprinted from The 401(k) Handbook, published by Thompson Publishing Group, Inc.)
by Martha Priddy Patterson
Long, long before 401(k) plans were envisioned, Polonius, a notorious figure in Shakespeare's dark play Hamlet, advised, "Neither a borrower, nor a lender be." Shortly after giving this advice, Polonius meets his end while engaged in the questionable activity of eavesdropping. Fast-forward to the 21st century, and we find a substantial number of 401(k) plan participants ignoring all of Polonius's advice and becoming both a borrower and a lender by borrowing money from their 401(k) plans and lending it to themselves.
As wrong as he may have been on other matters, was Polonius right at least about 401(k) plan loans? This musing is not generated by a rereading of Hamlet, but in light of the release of the IRS's final rules on plan loans. And the questions about the use of plan loans are questions many 401(k) plan sponsors puzzle over. (For a detailed discussion of he effect of these rules on 401(k) plan loans, see The 401(k) Handbook.)
Loans as a Lure
For many 401(k) plan participants, especially younger people or lower-paid workers, knowing that the 401(k) money is available through a guaranteed and speedy loan is a powerful incentive to enroll in the plan. Once enrolled, they may find saving much easier than they thought, and they may save more than they ever imagined. At the same time, they have the security of knowing that if the car needs a new transmission or the roof has to be repaired, the 401(k) plan can provide a quick and assured loan.
For the ultimate retirement security of nonhighly compensated employees (NHCEs), the importance of these 401(k) plan loans as a "lure" to join the plan should not be underestimated. Additionally, participation by NHCEs affects the retirement security of all other employees, given the 401(k) plan nondiscrimination rules' limits on the deferrals by highly compensated employees based on plan participation by NHCEs. With many 401(k) plans using extraordinary measures to increase NHCE participation, a plan loan feature is even more attractive to plan sponsors.
Better Than Hardship Withdrawals
Certainly, if a plan sponsor or plan participant has to choose between offering or taking a loan or a hardship withdrawal, loans are preferable by far to taking a hardship withdrawal for a number of reasons. First, once the hardship withdrawal is taken, the amount of money withdrawn can never be replaced in the 401(k) plan or any other tax-favored savings account. The opportunity for the magic of compounding and tax deferral is lost forever. Second, a participant under age 591/2 will pay income tax and the 10-percent early withdrawal penalty on the hardship withdrawal amount. Third, generally the participant will not be permitted to contribute to the plan again for 12 months, thereby losing the right to have tax deferral on his or her own money and the right to any matching contribution the employer might offer. Clearly, 401(k) plan hardship distributions are far more detrimental to retirement security than plan loans.
While the plan sponsor may recognize the damage hardship withdrawals can impose on a borrower's retirement security, it is tempting to offer hardship withdrawals rather than loans for several reasons. The hardship withdrawal does not require ongoing administration. The hardship distribution is granted when a participant shows a hardship. The plan sponsor issues the appropriate tax form, withholds the appropriate tax amount and has no further burden.
By contrast, the loan program will involve continuous administration over the life of the loan. The plan's security provisions generally require the employer to deduct loan repayments directly from payroll amounts due to the borrower. This requires coordination with the payroll department, the loan administrator and the 401(k) recordkeeper. Should the employee default on the loan, the plan sponsor must monitor the cure period for the loan; and if the cure period elapses without payment, the plan sponsor must treat the loan as a taxable distribution, including issuing the appropriate tax form and imposing the early withdrawal penalty of 10 percent.
These loan actions are not designed to generate warm and fuzzy feelings between the employer and the employee, but they are required by the IRS. If the employee later pays the defaulted amount, the plan must treat the repayment as a previously taxed amount and keep records isolating that amount for the life of the account. Given all these administrative burdens and costs, it is not surprising that 401(k) plan surveys show hardship distribution provisions being a more common plan design than plan loans. Nevertheless, plan sponsors should carefully weigh the potential for significant damage to retirement saving when offering hardship distributions rather than plan loans.
Trends in Plan Loans
The Federal Reserve Board's Survey of Consumer Finances offers some of the most comprehensive data available on how plan participants are borrowing from defined contribution plans such as 401(k) plans. Those data indicate that plan borrowers are acting responsibly. The data show the percentage of plans offering loans increasing steadily from 64 percent of plans in 1992 to 76 percent in 1998.
Not surprisingly, among families with plans that permit loans, the percentage of families holding such loans has increased in that period from about 13 percent to about 17 percent, and the median loan balance has increased from $2,200 to $3,100. But the good news about the increase in loans is twofold. First, the average loan balance as a percentage of the total account balance in the plan has decreased from about 25 percent of the account to 19 percent of the account. Almost 75 percent of loans are used for home purchases, bill consolidation, education and other investments.
No Free Lunch - or Free Plan Loan
But the disadvantages of plan loans should not be ignored or obscured. Although U.S. Department of Labor regulations require that loans be repaid at fair market rates, the rate of return the plan participant is paying to his or her account may well be considerably lower than the amount the money could be earning in another plan investment. The gap in the potential account earnings has been especially wide in the last few years, when commercial lending interest rates have been relatively low and returns on mutual funds have been consistently in the double digits. In most cases, the loan is a poorly performing investment for the participant's account when compared with other investments available in the 401(k) plan.
Additionally, the amount that has been removed from the 401(k) account is not available in that account to generate tax-deferred earnings. The reduction in the account balance significantly reduces these tax-deferred earnings, even though the loan is being repaid.
While many 401(k) plan loans do not impose loan fees, others do. Those fees can be as high as or higher than the fees for commercial loans. Plan participants should be alerted to this additional cost of borrowing.
Another disadvantage is the fact that the loan will be repaid with after-tax dollars. As a consequence, the "earnings" on the loan will also be repaid with after-tax dollars, and those dollars will be taxed again when ultimately distributed from the 401(k) plan.
Finally, if the plan participant quits or loses his or her job without repaying the loan, the loan will be treated as taxable income and as a distribution from the plan. Not only will the participant pay tax on the amount of the unpaid loan, but unless the participant is over age 591/2, the 10-percent early withdrawal penalty also will be imposed on the loan balance amount.
On balance, the right answer may be that the plan should offer loans, but discourage plan participants from taking a plan loan!
Martha Priddy Patterson is the director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.
Reprinted with permission from the December 2000 supplement to The 401(k) Handbook, ©Thompson Publishing Group, Inc., 2000. All rights reserved.
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