Retirement Plan Loans
Howard M. Phillips
The law allows participants in
most retirement plans to access retirement savings via a tax-free loan. “Most” because some government plans, and all
IRAs, do not allow for loans. Recent
studies have shown that about 85% of plans that can allow for loans do so; and
about 23% of participants in those plans use the provision.
Loan rules are contained in
Section 72(p) of the Internal revenue Code:
Highlights:
1, Maximum Loan – lesser of 50% of vested
account or $50,000 (with an additional limitation for multiple loans in the
same year).
2.
Maximum repayment period – 5 years level amortization
(exceptions – longer periods allowed for home purchases).
A discussion of
this area of retirement plan design must include the following:
1.
Advantages of allowing the loans
2.
Disadvantages of allowing the loans
3.
Issues involved in initiating, processing and
administering loans
4.
Are loan repayments taxed twice?
5.
Should loans be allowed in IRAs?
- Advantages
of allowing the loans
Formal studies
in both the private and the public sector have demonstrated that the existence
of a loan provision in a plan increases employee retirement savings, with
employees citing the comfort they take in knowing their retirement funds are
available in the case of an emergency.
An October 1997 study of loan provisions and 401(k) plans, conducted by
the Government Accountability Office, indicated that average annual
contribution amounts are 35% higher in 401(k) plans with loan provisions
compared with those without loan provisions.
A 2004 LIMRA study confirmed that an increase does occur with
availability of loans, albeit by only 21%.
Most
plan participants, especially those who don’t have access to a home equity loan
or a margin securities account loan, borrow through credit cards, which have
significantly higher interest rates.
Consolidating those debts through a loan from a retirement plan reduces
the cost of borrowing and frees up funds to enhance savings.
A mid-2009 research paper published by the Finance and Economics
Discussion Series, Divisions of Research & Statistics and Monetary Affairs,
Federal Reserve Board, Washington, D.C., authored by Fed economists Geng Li and
Paul A. Smith, concludes that there is significant positive value available
from participant loans in retirement plans.
Here are some of those conclusions:
a.
“…we find that many loan-eligible households
carry relatively expensive consumer debt that could be more economically
financed via 401(k) borrowing.”
b.
“…we
note that allowing households to repay 401(k) loans gradually even after
separation from their employment could improve household welfare by reducing
the risks of 401(k) borrowing.”
c.
“…401(k)
loans are not ‘double-taxed’, as is sometimes argued by analysts. The argument
is that since 401(k) loan repayments are not deductible, they are double taxed
when taxed upon withdrawal in retirement. But the appearance of double-taxation
is a misperception.”
d.
“The key
way a household could gain by using a 401(k) loan is by shifting high-cost debt
to relatively low-cost 401(k) loans. We focus on the potential gains from
swapping 401(k) loans with credit card and auto debt, which are two common
sources of higher- cost household debt.”
Economist Franco
Modigliani, who won the 1985 Nobel Memorial Prize in Economic Sciences for his
work in the field of retirement savings, explored the interplay between income,
consumption, saving, and wealth through the life cycle. Modigliani pointed out that in order to
maintain a stable utilization of monetary resources during life, people must
borrow.
Modigliani once
wrote:
One of the
most valuable and attractive options that the 401(k) (type) program(s) has
sanctioned is that of permitting plan sponsors to allow 401(k) and 403(b)
participants to invest a portion of their capital in a temporary loan to
themselves. This facility has the effect
of increasing the liquidity of the capital accumulated in the account, making
the accumulation much more affordable and attractive, especially for young people
and people of more limited income, who tend to have little by way of reserves
and therefore cannot afford to stash money away in a form where it becomes
inaccessible for decades, no matter how great the need. In addition, the 401(k)/403(b) self-loans
provide a source of credit that is not only available but also generally
cheaper than available alternatives, especially for younger and poorer people.
Author’s Note: Loans are now also available in
Section 457 retirement plans.
2.
Disadvantages
of allowing the loans
But there are disadvantages to making loans available
out of retirement savings. Significant
leakage from retirement savings accounts can occur when a plan participant
terminates employment. If the
participant has a loan in place at that date, he or she is compelled to repay
the loan or suffer a burdensome tax.
Other arguments against the practice include concerns that the
participant will stop making contributions to the plan while his or her loan is
in effect, that the participant will taxed twice since he or she is paying back
the loan with after-tax dollars, and that more access to credit will
necessarily mean greater debt for the plan participant.
- Issues
involved in initiating, processing and administering loans
a. Bureaucratic paper shuffling permeates the
conventional arrangement. Each loan requires a separate loan application, a
separate individually signed note, and a non-routine accounting
transaction. In addition, repayment is
left to the participant via an amortization schedule; or is assigned to a rigid
payroll deduction.
b.
Since
loans are difficult, participants facing a need will borrow to meet the entire
need at its outset.
c. Plan sponsors incur
substantial expenses to administer the program.
Fees account for part. Internal Staff resources account for much more.
d. Employment termination
inevitably closes out the loan, causing retirement assets to leave the system –
usually forever – to pay off the loan. Alternatively, the participant is
compelled to pay tax on the voided loan at a time when he can least afford it.
e. Participants must expose
their personal finances to clerks and supervisors with each borrowing.
f. Because loans are difficult and invade
privacy, participants carry substantial credit card debt, paying 18%-26% at the
same time they invest in conservative retirement plan investment options
earning far less.
How can we
remedy the leakage (loss) of retirement savings at termination of employment?
A terminating
employee has these choices with respect to his retirement account:
1)
Take the money; pay the tax and possible penalty; and
consume it.
2)
Directly rollover the money to an IRA, or a subsequent
employer’s Plan.
3)
Leave the money in the Plan, continuing that
relationship as an inactive participant.
Here are the
reasons why each of these alternatives has some negatives:
1)
Once consumed, that retirement savings is most likely
gone forever.
2)
IRA rollovers may not have a better investment menu
than that available in the x-employer’s program; emergency access to an IRA
account (or availability to pay off high interest cost credit card debt) will
involve tax and possible penalty; tax-free access via a loan is not available
in an IRA; there may be no subsequent employer, or a subsequent employer plan;
if there is a plan, that plan may not allow for loans, or may allow for
severely restricted access via a loan.
3)
If there is a loan, it has to be paid in full at that
time. If funds are unavailable to do so, more borrowing, possibly at high
interest cost, may be required to pay the tax and possible penalty.
A SOLUTION:
The record keeper adopts
a system which encourages terminating participants to leave their account
within the record keeper’s menu. This accomplishes the following:
a)
There is no “leakage” from retirement savings.
b)
The investment menu remains unchanged, including the
availability of loans.
c)
Existing loans need not be repaid at the time of
termination.
d)
The plan sponsor/staff experiences no additional work
or cost to allow the plan to have inactive participants.
New user-friendly systems to initiate, process, and
administer loans should remedy many of these problems. Among other things, new technology allows for
monthly billing, easy access to loan information by Internet or telephone,
summary loan information on a participant’s quarterly statement through a link
with the plan vendor, expanded loan repayment options, flexibility in repayment
amounts above the minimum required by the Internal Revenue Service, and greater
flexibility in handling leaves of absence, defaults, and repayment after
termination of employment.
The focus of these new systems is monthly billing for
repayments. An automated, monthly
billing system allows for loans to be granted without detailing a specific
reason, and it extricates the plan sponsor and the third-party administrator
from the loan initiation process and from setting up repayment after
termination of employment (no setup is needed because monthly billing
continues). And enhancing the monthly
billing system with loan initiation via a bank card brings additional positive
value, especially where the participant needs access to funds in an emergency
or in situations in which a balance transfer will immediately substitute a very
high bank-card borrowing cost for a significantly reduced borrowing cost
(freeing up funds for additional retirement savings).
New technology also enables plan record keepers, plan
sponsors, and third-party administrators to fine-tune the ways in which they
provide those loans. By allowing loans without
explanation, permitting loans to be initiated with a bankcard, and limiting
loans to a selected amount no greater than $10,000, the plan a\sponsor can
extricate itself from involvement in loan procedures. This would be especially meaningful for non-ERISA
403(b) plan sponsors that don’t want their employer involvement in providing
loans from the plan to kick the plan into being an ERISA 403(b) plan. It will also maintain privacy for the
participant and give the plan’s third-party administrator only one job – that
of initially determining if the line of credit that is requested by a
participant is within the limits of the plan’s loan procedures.
4. Are loan repayments taxed twice?
Loan proceeds that are repaid are later distributed
from a qualified retirement plan and are taxed once. The loan is a tax-free transfer, and when the
loan principal is repaid, ignoring investment growth, the transaction puts the
retirement account in the same position it would have been had there been no
loan. If we trace cash flow, we will
find that the financial transaction accommodated by the loan is fulfilled with
pre-tax dollars. Some future after-tax
money is used to pay back the loan interest, and ultimately is taxed again. However, the net result of all of the flow
out of the plan is a single tax on the amount of the loan principal in the
distribution (when the plan account is distributed, the participant receives a
double-taxed distribution but already owns a never-to-be-taxed financial
transaction, the algebraic net of which is a single tax).
5. Should loans be allowed in IRAs?
The key reason to consider loans in IRAs is the
current initiative to require that employers (with a very small employer
exception) provide for a payroll deduct IRA for employees where that employer
does not sponsor another retirement plan.
Since the initiative includes the provision that an employee can decline
participation, allowing for a loan will give all employees the comfort in
knowing they have access to a tax-free loan should such a pre-retirement need
occur. Several noteworthy studies have
shown that plans allowing for loans have significantly greater retirement
savings participation and contribution amounts than plans that do not allow for
loans.
Section 72(p) and its regulations should become
applicable to all non-Roth IRAs (traditional TRAs, payroll deduct IRAs,
rollover IRAs, SEP-IRAs). One
consideration for this applicability could be a modification in the $50,000
limit in Section 72(p). Perhaps that
limit should be reduced for non-rollover IRAs to $15,000 (bearing a similar
relationship to the $50,000 limit as does the contribution limit-IRA vs.
401(k)).
The burden of loan initiation, processing and
administration will not be placed upon employers, or IRA custodians. This is so because there are available today
fully automated systems for loan initiation, processing and administration of
Section 72(p) loans.
Those involved in bringing payroll deduct IRAs to
Congress for legislation enactment are urged to consider this modification in
the proposed bill so as to lessen significantly the number of employees who
will reject participation, and will allow other IRA holders to have an access
to funds in an emergency, such that that retirement account will be restored by
repayments (rather than having to withdraw, suffer the tax, without repayment,
in order to handle the financial need).
Finally, a note for positive public policy. An IRA owner who is paying very high interest
costs for credit card debt would be allowed to transfer that debt (within
limits) to an IRA loan, paying himself the prime interest rate, plus a small
administrative fee. This debt service
reduction will free up funds to increase retirement savings.
The advantages of loan availability in retirement plans
significantly outweigh the disadvantages.
However, these advantages disappear unless the loan initiation,
processing and administration is simplified.
All current loan systems should take this quiz:
If one or more of these questions is answered “NO,” then
a contemporary loan system will be an improvement to the loan system now in
place: Does the current loan system do the following:
1. Allow for immediate balance
transfer from high interest cost credit card debt to a loan where interest at
prime (today 3.25%) is paid to the participant’s account? Even with the loan
administrative fee, the 18%-26% credit card interest cost is replaced with
about 6%; thereby increasing personal disposable income, increasing retirement
savings, or both.
2. Allow for a line of credit to
be held in a Loan Fund earning higher yields than plan investments held in a
money market (Loan Fund today-2.5% vs. money market rates of .25% or less)?
Therefore, an unused line of credit earns 2.5% at today’s rates; a used line of
credit earns 3.25% at today’s rates.
3. Allow for participant privacy
in applying for a loan? If a reason is needed for the loan, then the
participant must reveal his financial duress to his employer, and the employer
must take the time to determine if the reason is valid (or violate the plan’s
terms). Loans do not require a reason (since the law does not require it).
4. Provide
for immediate access to funds in the account in an emergency?
5. Remove the employer and the
TPA from adjusting loan repayments for leaves of absence (different for
military vs. non-military leaves)? — and from the handling of defaults?
6. Provide loan information to the participant 24/7?
7. Give the participant a loan calculator to
assist the participant deliberating a loan?
8.
Allow the participant to set up one line
of credit, with a single one-time application, so that that line of credit may
be used in smaller pieces than having to apply once for a larger loan so as to
avoid the hassle of applying for smaller loans as they are needed?
- Allow for variable payments above the
minimum required, including a full payoff?
10. Allow the participant to continue repayment after termination of
employment, without the
creation of
and handling of coupon books by the employer or the record keeper or the
TPA? Such a
continuation of repayments avoids the participant’s having to find the
money to
repay the loan, or pay the tax and possible penalty if the loan cannot be
repaid.
Borrowing is
a fact of life. A limited loan from one’s retirement account offers an
inexpensive way to handle borrowing needs. Millions of retirement plan
participants have utilized their plan’s loan provision. New technology now
available to initiate, process and administer these loans has enhanced its advantages.
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