In speaking with plan sponsors attending The Plan Sponsor University (TPSU) programs around the country, the topic of 401k loans inevitably arises. In almost every program, plan sponsors get somewhat uncomfortable when the subject is addressed. 401k loans are often viewed as a “necessary evil” in running a defined contribution retirement plan, but the reality is that they go wrong more often than you think.
Many sponsors feel that offering loans is necessary to induce participation and that it is a compassionate thing to offer in the case of financial hardship. A participant seeking a loan from their retirement plan in fact is legally only granted (with few exceptions) in cases where hardship exists, hence the term “hardship loan.”
The sobering reality of these types of loans is that they often lead to further hardship and can be very costly to both the sponsor and the participant in the form of lost opportunity, fines for errors and total cost of borrowing when factoring taxes.
Statistically speaking, the probability of a 401k loan going badly for the participant and the sponsor are alarmingly high.
- Nearly 20% of all participants will have outstanding loans from their 401k plan at any one time,
- Nearly 40% will have taken a loan from their 401k plan in the past 5 years,
- Nearly 86% of participants who leave a job with a loan outstanding default on the loan repayment schedule,
- 10% of all 401k loans are never repaid,
- Employers who allow multiple loans, default rates increase for those who take multiple loans,
- Concept of “double taxation” for a 401k plan,
- Risk of plan sponsor errors in following IRS and ERISA guidelines in granting 401k loans can result in significant fines for the plan sponsor.
Hardship loans may be unavoidable in many cases, but plan sponsors should have a system of strong controls for following ERISA and IRS guidelines to ensure they are granted according to regulations. In addition, compelling a loan applicant to have a mandatory consultation with the plan advisor or other education program may mitigate the risks associated with taking a loan against a retirement plan.