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Misleading Plan Sponsors Regarding Plan Loans Hurts Participants

05/20/2019
By Jack Towarnicky

Myths, Misdirection, Misrepresentations

Here is my challenge to any and every benefit professional or any plan participant: There is no valid reason to curtail access to qualified plan loans.

Disagree? Let’s debate. Send in your reasons. I will respond in a future blog post – and – if necessary, I will confirm when you are right and when I am wrong.

Enough is enough. At the urging of experts, too many plan sponsors have curtailed access to liquidity via plan loans. And, at least once a month, sometimes more frequently, plan sponsors suffer through another article, webinar, or conference presentation where a service provider or plan advisor encourages then to curtail liquidity via plan loans. Here is a recent example.1

To kick off the debate, none of the reasons cited in this article are valid. I’ll address all 10 reasons given in this article2:

Reason #1: Interest on a plan loan is usually not tax deductible.
When properly secured, the interest a participant pays may be tax deductible whether the loan is from a qualified plan or from a commercial source.

Reason #2: Plan loan interest rates may exceed commercial loan interest rates.
For most participants, plan loan interest rates are less than rates on loans from commercial sources. Regardless, before borrowing, participants should always compare plan loans with other available liquidity.

Reason #3: Loan interest may be less than the return on equity investments.

Few if any participants should be 100% allocated to equity investments. After initiating a loan, the participant should always rebalance her account to her target allocation – so the plan loan principal is treated as the fixed income investment it is. Where the plan loan interest rate is higher than the returns available on fixed income investments and less than the rate the participant would have paid on a commercial loan, the participant improves both her retirement preparation AND her household wealth.

Reason #4: Plan loan repayment schedules are inflexible; plan loans must be repaid in full upon separation or taxes and tax penalties may apply.
Plans can offer enough flexibility, so participants can avoid defaults, including:
• Electronic banking, to allow continuation of loan payments after separation,
• Line-of-credit processing offers great flexibility through multiple loans, and
• The Tax Cuts and Jobs Act of 2017 allows repayment at any time before the date the individual files her tax return for the year in which default occurred (by April 15th, or October 15th if filing for an extension, of the following year)
.

Reason #5: Fees on commercial loans may be less than fees on plan loans.
For most participants, fees and interest rates on plan loans will be less than those on loans from commercial sources. Regardless, before borrowing, participants should always compare plan loans with other available liquidity.

Reason #6: Participants may obtain multiple plan loans.
I’d bet you had (will have) a car loan, a student loan, and/or a home mortgage sometime during your working career. The source of funds doesn’t matter if you got the best interest rate, repaid the loan and maintained your desired investment allocation.

Reason #7: Participants may reduce their contributions when repaying the loan.
Where the plan loan has a lower interest rate and payment amounts compared to a commercial loan, the participant is less likely to reduce her contributions.

Reason #8: Plan loan payments are made with after-tax dollars. Interest earnings, including plan loan interest may be taxable income when distributed at retirement. So, those same dollars are “double taxed.”
No, those are not the “same” dollars. Payments of loan interest are made with after-tax dollars – whether the loan is a commercial loan or a plan loan. Interest may or may not be tax deductible. Interest on fixed income investments, whether a bond or a plan loan, will receive the same tax treatment when paid. So, for example, where a commercial loan or a plan loan is secured with a home mortgage, the interest paid (to the bank or to the plan) may be tax deductible. And, where the loan principal borrowed from the plan is Roth 401(k) assets, the interest paid on the plan loan may be tax free when distributed.

Reason #9: Employers don’t want the plan to become the “bank” for participants.
Seventy plus percent of American workers live paycheck-to-paycheck.3 So, most plans offer plan loans and hardship withdrawals. A plan that does not provide tax-advantaged liquidity will be underutilized as participants will only save what they believe they can afford to earmark for retirement. Plan loans are clearly superior to hardship withdrawals. Workers must save up before taking a loan. This limited banking functionality has helped millions successfully prepare for retirement: Save, Get the Match, Invest, Accumulate, Borrow to Meet a Current Need, Continue Contributions While Repaying the Loan, Rebuild the Account for a Future, Larger Need. Repeat as often as necessary up to and through retirement.

Reason #10: A loan feature creates fiduciary responsibilities.
Yes. However, plan sponsors should avoid service providers who are unable to successfully process plan loans. Participants should pay all loan processing costs – including any costs to correct processing errors/mistakes.

Got more reasons not to offer plan loans? Send them in: jtowarnicky@usaretirement.org.


1RMS, Why Some Retirement Plans Do Not Offer Loans to Participants, 5/10/19, Accessed 5/17/19 at: http://www.consultrms.com/Resources/10/Plan-Design/44/Why-Some-Retirement-Plans-Do-Not-Offer-Loans-to-Participants
2Towarnicky, Qualified Plan Loans, Evil or Essential, Benefits Quarterly, 2nd Quarter 2017, Accessed 5/17/19 at: https://www.ifebp.org/inforequest/ifebp/0200570.pdf; See also: 401(k) Does Double Duty as a Holistic Financial Wellness Tool, 4/4/19, Accessed 5/17/19 at: https://www.psca.org/blog_jack_2019_21; Impediments to Saving for Retirement – Part 2 - The Solution? The Right Kind of Liquidity, 11/9/18, Accessed 5/17/19 at: https://www.psca.org/blog_jack_2018_51; It is Not Borrow to Save, But Save to Borrow! 10/9/18, Accessed 5/17/19 at: https://www.psca.org/blog_jack_2018_45
3American Payroll Association, Getting Paid in America, September 2018, Accessed 5/17/19 at: https://www.nationalpayrollweek.com/wp-content/uploads/2018/09/2018GettingPaidInAmericaSurveyResults.pdf

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