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A 403(b) Loan Feature that 401(k) Plan Sponsors Should Consider

There is a difference between 403(b) and 401(k) plans that is not captured in most formal 403(b)/401(k) comparisons - and it has to do with the repayment of outstanding loan balances after an employee terminates employment.

In most 403(b) plans, the former employee is permitted to continue loan repayments as if he/she was still an active employee (typically by ACH deductions from a checking account). However, in many 401(k) plans, when an employee terminates employment, he/she must pay off the entire loan balance by April 15th of the year following the year of employment termination (or October 15th, if the employee files a tax return extension). If not repaid by this deadline, the loan balance is taxable as if it were a withdrawal, with an added 10% penalty if the employee is under age 55 on 12/31 of the year of employment termination. Obviously, this provision can be a financial minefield for many employees, particularly if a large amount is borrowed.

Why is there such a big difference between 401(k) and 403(b) plans? The answer lies in the history of 403(b), where the concept of employer-sponsored plans is relatively new. Decades ago, 403(b) accounts were considered individually owned, with greater participant control. As such, the employment relationship with respect to administration was less significant - which explains why participants were free to continue loan repayments after termination of employment.

However, beyond this explanation, there is no reason that loan repayments cannot be continued following termination of employment in a 401(k) plan. Since most 403(b) plans allow for repayment after termination without major consequences, I suggest that 401(k) plan sponsors work with their recordkeepers to determine whether this feature could be adopted in their plan, ultimately eliminating a major headache for 401(k) plan participants.

Do you disagree with me about continuing loan repayments after termination of employment? Let me know on LinkedIn, Twitter or at info@cammackretirement.com!

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

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