Should Retirement Plan Sponsors Be Limiting Plan Loans?
As I have written in the past, I am not a fan of retirement plan loan overutilization, for a variety of reasons. However, loan regulations clearly provide plan sponsors with a great deal of flexibility in this area, including the ability to be overly permissive, quite restrictive, or somewhere in between with respect to their loan policy.
However, during a conversation with Jack Towarnicky of the American Retirement Association (a recent guest on our Revamping Retirement podcast), I started to rethink this issue, specifically with regard to the maximum number of outstanding loans a participant is permitted to have.
Jack reminded me that outstanding retirement plan loans are actually transactions that can be quite beneficial to a participant, for the following reasons:
- Loans are preferable to plan distributions — The tax consequences of distributions, which include a 10% penalty for most situations in which a participant is under age 59½, are so bad that they often result in participants owing the IRS, instead of owing themselves - which would be the case if they had simply borrowed from the plan instead of taking a withdrawal. Also, if funds are withdrawn, the money leaves the plan and never comes back, eroding retirement wealth. With loans, retirement wealth is generally preserved.
- Choosing a retirement plan loan is often a better alternative to borrowing in the commercial marketplace — This assumes that the loan was necessary to address a particular need that could not be addressed from other monetary sources in the first place, but it is true that a participant could save a significant amount of interest and other charges by electing to borrow from the retirement plan, rather than from an outside source.
- The chances are that if an individual has a number of outstanding loans, they have a lot of retirement savings as well — A person with multiple outstanding loans is unlikely to have less than $10,000 in their account, due to the fact that the statutory borrowing limit is generally 50% of a participant’s account balance, or $50,000, whichever is less. This is important, since the most critical timeframe for building retirement wealth is early in an individual’s career, when the magic of compounding is most potent. Thus, the statutory rules effectively prevent these participants from doing too much damage to their account balances via borrowing. On the contrary, individuals with multiple outstanding loans tend to be those with larger account balances, and the loans themselves tend to be on the smaller side, due to the $50,000 cap. For these accounts, the impact of borrowing is less significant on retirement wealth.
Taking these points into consideration may lead a plan sponsor to be less restrictive in limiting the number of outstanding loans for a participant. However, the degree to which flexibility should be permitted may vary from plan to plan. For example, some retirement plans have participants borrowing to pay off high-interest debt, only to re-incur that debt all over again a few years later, because the individuals didn’t address their income-versus-expense issues that caused the debt in the first place. Thus, they must borrow again, because now they have the credit card debt again and less income due to loan repayments. If participants continue this cycle, they put themselves in a significant financial hole that may result in more drastic solutions (e.g., credit counseling). Keen plan sponsors understand their participants’ financial behaviors. Thus, the plan sponsors of plans like these should look to either provide better participant financial wellness education and/or be more restrictive in the number of loans they permit to be outstanding.
Finally, Jack noted that “borrowing from yourself” via a retirement plan loan is not the type of debt that can be discharged in a bankruptcy, thus, a participant would still be responsible for paying off the loan even if bankruptcy is declared. Therefore, participants should be educated on the fact that the last place they should borrow from is a retirement plan, if they are financially insecure.
What limits do you think are appropriate on the number of outstanding retirement loans? Or should such loans be unlimited? We would love to hear from you on LinkedIn, Twitter or at firstname.lastname@example.org
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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