Plan Loans – The Pros and Cons
By Lisa Haberman, MBA, MAM, ChFC, CLU
One of the most valuable benefits that an employer can offer is the ability to save for retirement. For employers, sponsoring a qualified retirement plan helps attract and retain quality candidates. For employees, a retirement plan is one of the primary resources used to manage long-term financial security while also providing flexibility to help with short-term financial needs.
Employers may allow participants to take loan distributions from their qualified retirement plans. If loan distributions are permitted, there are a few details that participants should be aware of when deciding whether to take a loan distribution to meet short-term financial needs.
Availability
Pro: A participant does not have to wait for a distributable event to request a loan distribution. Generally, participants need to wait until there is a distributable event in order to receive assets from their retirement plan account, but this is not the case if a participant takes a loan distribution. Another plus to consider is that participants who take a loan against their retirement assets don’t need to worry about obtaining approval from a credit union or banking institution. Loans are generally available from qualified retirement plans at the time a participant actually needs the funds.
Con: Not all employers permit loan distributions. It is important to review the plan document to see if loans are allowed. If they are, then loans are generally available for any purpose, including the purchase of a primary residence. Participants should review the plan’s loan policy to determine if there are any special restrictions regarding loan distributions, as employers may choose to limit the reasons for requesting a loan distribution or not permit loan distributions at all.
Con: Spousal consent rules may apply. While many employers do not require spousal consent to obtain a loan distribution, they may require written spousal consent for a loan distribution greater than $5,000. If this is the case, a loan distribution will not be available unless written consent is received from the participant’s spouse.
Terms
Pro: A participant’s credit score is not affected when a loan distribution is requested. Many participants worry that taking a loan will adversely affect their credit score. Treasury Regulation 1.72(p)-1, A-3, requires employers to maintain a legally enforceable agreement (loan contract), but the employer does not report loan distributions to credit reporting agencies.
Pro: Credit history does not directly influence a participant’s ability to request a loan distribution. Loan distributions must follow Department of Labor (DOL) guidelines to avoid being considered a prohibited transaction between the plan and a party-in-interest (DOL Regulation (Reg.) 2550.408b-1). One of these rules requires loan distributions to be available to all participants and beneficiaries on a reasonably equivalent basis (DOL Reg. 2550.408b-1(b)). To meet this standard, the employer must (1) make loan distributions available to all plan participants and beneficiaries without regard to the individual’s race, color, religion, sex, age, or national origin, (2) consider only factors that would be reviewed in a commercial setting (including creditworthiness), and (3) refrain from unreasonably withholding a loan distribution from any applicant after careful consideration of all relevant facts and circumstances. Credit history is only one of many factors considered and when reviewed with all other relevant information, may not unreasonably preclude a participant from receiving a loan distribution.
Con: Loan distributions may not meet the participant’s total short-term financial needs. Qualified retirement plans are primarily designed to encourage saving for retirement and any distributions taken before normal retirement age are usually penalized or taxed. But loan distributions taken before retirement age are exempt from penalty or tax as long as certain IRS requirements are met. Internal Revenue Code Section (IRC Sec.) 72(p)(2) provides guidance regarding maximum loan amounts, repayment terms, and level amortization schedules that must be followed to avoid penalties or taxation of loan distributions.
For example, the maximum loan amount that a participant may borrow at any time is one-half the present value of his vested account balance, not to exceed $50,000*. The maximum loan term is set at five years unless the loan is for the purchase of a principal residence, in which case the loan term is extended to a maximum term determined by the employer.
These limitations on loan distribution amounts and repayment terms may be too restrictive for certain short-term financial needs, as the participant may not have adequate distributable assets or a long enough period of time to accommodate a reasonable repayment amount.
Payments
Pro: Easy payments through payroll deduction. Plan loans must be repaid according to a level amortization schedule (IRC Sec. 72(p)(2)(C)), with payments consisting of both principal and interest. Many participants opt to—or may be required to—make loan payments in the same manner as they make elective deferrals—through payroll deduction. But employers may permit other forms of payment, as long as the principal and interest are paid on at least a quarterly basis.
Pro: Payments are credited back to the participant’s account. When payments are made back into the plan, the principal and interest amounts are credited back to the individual participant’s account—not to the plan’s general account.
Con: The participant may have to repay or make up the entire loan balance after terminating employment to avoid taxation and possible penalty. Participants may be required to make up any remaining loan balance within a limited time after terminating employment, since—in today’s recordkeeping/plan administration environment—it’s common for loan policies to permit only payroll withholding loan repayment. If the participant does not have the resources to repay the loan in full, the participant may also have the option to roll over the unpaid loan balance to an IRA or another qualified retirement plan (if such plan permits). Rollovers allow participants to avoid the potential penalty and to delay tax consequences. If a loan is rolled directly to another employer plan, it would likely be reported on IRS Form 1099-R as a direct rollover. If the employer reports the offset loan on Form 1099-R as distributed and taxable—and potentially subject to a 10% early distribution penalty—and a cash amount equal to the loan balance is subsequently rolled over to an IRA, that rollover would be reported by the receiving IRA custodian on IRS Form 5498. (Prior to the SECURE Act, the cash rollover of an offset loan to an IRA had to be accomplished within 60 days, but can now be done at any time up to and including the participant’s tax return due date for the year of offset, also including tax return filing extensions.)
Overall, participants should weigh the pros and cons when deciding whether to take a plan loan distribution. Remember, while loan distributions are a viable option, the primary purpose of a qualified retirement plan is to provide for long-term retirement savings.
*The maximum amount was increased to $100,000 for qualified individuals requesting loan distributions from March 27, 2020, to September 22, 2020, per the CARES Act.
