401(k) Loans: The Good, The Bad and The Ugly

October 05, 2016

loan, 401k

Joel Manzer

3182161_l.jpgAs a business owner, there may be times when an employee may turn to you to ask for help, such as an advance in pay, in order to address a particular hardship.  Of course you want to help, but lending money to an employee should only be considered after all other options are pursued.  There are risks and rewards associated with helping an employee in times of need, many can be associated with being legally compliant, which we share here:  “Employer Lending: Exposing Risks and Rewards[1]

There are other options that are available without becoming a lender – such as a 401(k) loan.  

According to SBA.gov,  If the employee has an account in your 401(k) and the plan allows loans, the business doesn’t have to become a lender. Instead, the employee can borrow up to 50% of his/her account balance (up to a maximum of $50,000). The plan must charge a reasonable rate of interest and repayment must be made in level payments over a period of no more than five years (there’s an exception to this repayment period for loans to buy homes). But caution the employee that if he or she leaves the job—voluntarily or otherwise—the loan must be repaid in full (usually within 30 or 60 days). The failure to do this results in having the outstanding balance treated as a taxable distribution; if the employee is under age 59-1/2, the distribution is taxable and subject to a 10% penalty. Find details about plan loans from the IRS[2]

All this sounds pretty good and reasonable, right?  The Employee is able to obtain funds and address their financial hardship, and business risk is mitigated.  Or so it seems…

The challenge that business owners need to be mindful of in regards to 401(k) loans to employees is in association with “pension leakage” for fiduciary liability.  Pension leakage describes when assets intended to support the employee in retirement ‘leak’ out of tax-favored 401(k) plans prematurely. 

According to a Gallup poll, “The majority of non-retired investors in the United States say their employer offers a 401(k) plan, and of these 89% say they participate in it.  Yet 21% of those who participate in such a plan say they have either taken out a 401(k) loan or even taken an early withdrawal from the plan in the last 5 years.[3]

The bad news is that if gone unchecked, plan borrowing outgrows the plans original purpose, and the funds are not sufficient to accommodate the employee(s) when expected.  Of course the ugly side is that there are there are potential legal and tax implications associated with a 401(K) loan in case it defaults.

But there are alternatives that can be considered, such as having a third-party available to manage loans when an employee needs some extra funding during a financial hardship.

A third-party can not only facilitate an employee loan program, but also have tools available to help the employee be better prepared in the future with financial education.


[1] https://www.finfit.com/Resources/Documents/FinFit_EmployerLending_WhitePaper.pdf

[2] https://www.sba.gov/blogs/lending-money-your-employee

[3] http://www.gallup.com/poll/180311/one-five-investors-tapped-401-prematurely.aspx

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