The Pros And Cons Of Offering 401(k) Loans To Employees

By: Mary Anne Cody and Neil J. Smith

In the current housing and banking crisis, it has become more difficult for consumers to obtain credit based upon the equity in their homes because of the decline in housing values and the tightening of lending standards.

Consequently, increasing numbers of employees are beginning to take advantage of 401(k) plans that offer the option of taking funds out of the retirement plan in the form of a loan.

When drafting or amending a plan, the employer determines whether to include a loan feature or not. Employers should carefully examine their 401(k) plans and determine whether they want to make loans available to participants.

As with all Employee Retirement Income Security Act (ERISA) governed plans, there are numerous regulations to which the employer must adhere. Ultimately, the determination regarding the addition of a loan feature should be governed by both the direct impact on the employer by allowing loans, as well as the potential impact on the plan participants themselves.

The primary benefit to the company in allowing 401(k) plan loans is the ability to offer a benefit to its employees at a relatively low cost.

Unlike permissible hardship withdrawals that are subject to tax as a distribution, loans from 401(k) plans are not taxed as distributions as long as the participant repays the loan.

Employers, as the plan administrators, can charge their employees various fees for the loan application and the processing of the loan.

However, offering loans in a 401(k) plan is not without risk to employers. Loans that become delinquent are treated as distributions.

Moreover, employers can find themselves unintentionally acting as a creditor. In addition, offering loans can increase the costs of administration of the 401(k) plan.

A recent innovation that may reduce the administrative costs to employers is the 401(k) debit card. These debit cards allow employees to utilize their 401(k) loans as collateral for lines of credit.

The debit-card system allows employers to dispense with the expense of administering 401(k) loans, and permits employees to draw upon their retirement funds with a minimum of effort, sometimes even simply by going to an ATM.

Employers should also be aware that 401(k) loans also pose risks to an employee/ participant's financial well-being.

Although participants may find the loans to be quick and easy to obtain since no credit-check is necessary, imprudent borrowing from a 401(k) plan can have disastrous long-term financial consequences.

The first problem is that participants who fail to pay back their loans are subject to high penalties.

Not only will borrowers under the age of 59 who fail to pay back their 401(k) loans find that their loans counted as taxable income, but they also are subject to an additional 10 percent IRS penalty.

This means that participants/borrowers who have defaulted on a 401(k) loan not only are subject to liability for the principal and interest due on the loan, but they also face a new and possibly quite large tax liability that they may not be able to afford.

The second problem is that participant/borrowers are repaying the loans with after-tax dollars, which reduces the tax-advantages of the 401(k). The ideal situation is to be funded entirely by pre-tax dollars.

The 401(k) does not actually generate any new money that was not already there, but only shields that income from some negative tax consequences.

The third problem is that a pattern of heavy borrowing from 401(k) plan assets would rapidly deplete employees' nest eggs, and leave them with little except debt upon entering into retirement.

Finally, the availability of a 401(k) debit card could make it far too easy for employees to deplete their long-term retirement plan assets for short-term needs.

Therefore, when considering the addition of a loan feature, an employer must consider the profile of its work force.

If the work force consists of persons who are subject to a high rate of delinquency in repaying loans, then the 401(k) loan program may cause more harm to the work force than good.

If, however, the employer's work force consists of employees who are good credit risks and are sufficiently financially literate to appreciate the potential tax consequences of such loans, then the employer should give consideration to the idea of offering these loans to its employees.

Mary Anne Cody and Neil J. Smith are attorneys with Mackenzie Hughes LLP in Syracuse. They handle business, tax, bankruptcy, and creditor's right issues for a variety of clients. Contact them at (315) 474-7571.