401(K) Loans: What Employers Should Know About This Benefit
For many employees, knowing they can tap into their retirement savings in the event of an emergency by taking a 401(k) loan can give them peace of mind – and boost their 401(k) participation. But if you’re thinking about this feature, there are a lot of factors to consider in deciding if it’s right for your organization, from loan rules to administrative requirements.
Complete Payroll Solutions is a third-party administrator that helps companies of all sizes design the ideal retirement plan for their employees. To help you understand if a loan feature is a good idea for your organization, here we’ll discuss:
- What is a 401(k) loan
- How does a 401(k) loan work
- Why would I offer a 401(k) loan feature
- Can I deny a 401(k) loan
- How does an employee repay a 401(k) loan
- What happens to a 401(k) loan when an employee changes jobs
- What administrative tasks do I need to worry about with a 401(k) loan
After reading this article, you’ll be able to decide if a 401(k) loan feature is right for your business and your employees.
What is a 401(k) loan?
A 401(k) loan is a retirement plan feature that allows employees to borrow from their retirement account balance for a short-term purpose like an emergency. Unlike a traditional loan, a plan participant doesn’t have to undergo any type of credit check or deal with a lender; they just have to qualify under the rules of your plan, which we’ll discuss in a bit.
Generally speaking, there are 2 types of 401(k) loans: a general purpose loan and a residential loan.
- General Purpose: This type of loan can be used for any reason when an employee needs cash such as when buying a car or paying for college. When applying for the loan, the employee doesn’t need to explain why they need the money or what they plan to do with it. The maximum repayment term for a general purpose loan is 5 years.
- Residential: An employee who needs to take a loan to access money to buy a primary residence is called a residential loan. For this type of loan, an employee must provide supporting documentation, like a purchase and sales agreement. These loans offer longer repayment terms than a general purpose loan. We’ll talk about repayment later.
For either type, the IRS sets a maximum amount that an employee can borrow. That amount is 50% of the employee’s vested balance in the plan or $50,000 minus the highest outstanding loan balance an employee had previously – whichever is less. Let’s look at a couple of examples:
- An employee has $10,000 vested: They could borrow $5,000.
- An employee’s balance is $200,000 vested: If they’ve never taken a loan, the maximum they could borrow would be $50,000; however, if they took out a loan 9 months ago for $20,000, the most they could borrow now would be $30,000.
How does a 401(k) loan work?
When you incorporate a 401(k) loan feature into your retirement plan, you’ll spell out how the borrowing works. For example, you’ll describe the:
- Minimum or maximum amount an employee can borrow
- Loan term
- Need for spousal approval, if required
- Interest rate and fees
- Ability of employees to direct where the loan money comes out of
If an employee decides to take a 401(k) loan, they’ll apply and either receive the money directly in their bank account or by check.
An employee may request their loan repayment term between 1 year to a maximum repayment term of 5 years. For a residential loan, the maximum repayment period allowed is 30 years, although an employer may elect a lesser repayment period such as 10 years.
Loan repayments are made through payroll deduction according to the employee’s payroll frequency to ensure scheduled and recurring repayments based on the promissory note and amortization schedule. Employees can always pay a loan off sooner without any prepayment penalty.
Why would I offer this feature?
The primary reason you’d want to offer a 401(k) loan feature is to drive plan participation. That’s because some employees may not want to enroll in a plan and set aside money if they think they can’t easily access it in case of an emergency or life-changing event. By allowing loans, employees know they’ll be able to use the funds if they need to.
And when they do take a retirement loan, it’s a non-taxable event. That means an employee doesn’t claim a 401(k) loan when they file their taxes. And since the principal and interest on a 401(k) loan goes back into the employee’s retirement account, they’re really paying themselves back.
If you decide to offer a loan feature, however, you’ll want to make sure you educate employees about the use of it. For instance, you’ll want to explain that loans should only be used when necessary since they can impact an employee’s retirement savings goals because they’ll lose the compounding of the loan distribution. And you should share how, when they take a loan, it’s subject to double taxation since employees have to make the repayments with after-tax dollars and then be taxed on the retirement distribution.
Can I deny a 401(k) loan?
If you allow 401(k) loans, they must be made available to all plan participants. That means you can’t discriminate as to who takes out a 401k loan. However, you may restrict access to 401(k) loans as long as the limits apply to all plan participants. For example, you may only allow a 401(k) loan for hardship situations or you may only allow one outstanding loan at a time.
How does an employee repay a loan?
Your plan documents will describe the terms of 401(k) loans, including repayment schedules. Loan repayments are made via payroll deduction based on the employer’s payroll frequency. This money is repaid on an after-tax basis (not pre-tax) and will be reinvested according to the employee’s current fund elections.
If an employee falls behind on their repayments, and no payment is made in the quarter following the last quarter a payment was received, they will be deemed in default of the loan. If that happens, the outstanding loan balance will be considered a taxable distribution and must be reported as taxable income when the employee files their taxes.
For example, if an employee leaves in early September and they made a third quarter payment, but doesn’t make another payment by December 31, the outstanding loan balance would be considered a taxable event at that time.
That means the employee will be responsible for all tax consequences and penalties (if under the age of 59 ½), although there are some exceptions regarding loans going into default (e.g. leave of absence).
What happens to a 401(k) loan when an employee changes jobs?
When an employee leaves your company, the outstanding loan balance becomes due. Unless the employee repays the loan, the outstanding balance will be considered taxable income the earlier of (1) an employee taking distribution of their entire retirement account or (2) the quarter after the quarter the last payment was received.
Again, the employee will be responsible for all tax consequences and penalties (if under the age of 59 ½).
What administrative tasks do I need to worry about?
When it comes to administering a 401(k) loan feature, there are several things you’ll need to manage. These include:
- Repayment schedules: 401(k) plan loan repayments must be made at least quarterly to remain compliant. So you’ll need to create a loan amortization schedule based on the employee’s payroll frequency to ensure timely and consistent loan repayments.
- Leaves of Absence and Deferrals: An employee who goes out on a leave of absence may defer 401(k) loan repayments for up to one year without the loan going into a default status. But once the employee returns, you’ll need to make sure they bring the outstanding loan balance current by (1) making up the missed payments or (2) re-amortizing the loan for the missed payments).
- Notifying Employees About Missed Payments: Loan monitoring reports will notify you of any employee who is delinquent in their loan repayments. Once you receive these, you’ll have to reach out to the employee and advise them to either (1) bring the loan current or (2) have the loan deemed a taxable distribution and inform the employee of the consequences.
- Re-amortizing Loan: Sometimes, when an employee returns from a leave of absence like after maternity leave, they may want to re-amortize the 401(k) loan. Your third-party administrator (TPA) will calculate the new loan payment amount and revise the amortization schedule, which you’ll need to provide to the employee.
- Reporting Requirements: With a 401(k) loan feature, you must provide the following reporting for compliance purposes: promissory note (terms of the loan including amount, interest rate, total interest, first loan repayment date, length of loan, loan repayment frequency, and term agreement), amortization schedule, loan monitoring report, and delinquent loan report.
How to Add a 401(k) Loan Feature
As you can see, there’s a lot to consider when it comes to 401(k) loans. And managing the plan feature may be administratively overwhelming, especially if you don’t have the staff in house to stay on top of everything. To make things easier on yourself and your team, you may decide to work with a third-party administrator to help you design and manage your plan.
As you research options, you may be wondering whether Complete Payroll Solutions could be a good fit for your company. Complete Payroll Solutions can be an ideal 401(k) partner if you’re looking for a third-party administrator who:
- Can help with flexible plan designs based on your needs and those of your employees
- Provides one-on-one support from a dedicated professional
- Specializes in meeting your legal obligations
To learn more about our 401(k) offerings, read our next article on our retirement plan products and services. If you’re interested in learning more about what factors to think about as you search for the ideal TPA, check out our checklist on the 7 things to consider when choosing a 401(k) provider.