(Courtesy of Elezor M. Preil) If your employer offers a 401(k), you probably know the basics: Deposits are made on a pre-tax basis, earnings accumulate tax-free and distributions after age 59½ are taxed as regular income. These features, along with other items, such as loans, hardship provisions, early withdrawals and required minimum distributions, are determined by government regulations.
What many participants may not know is that employers, as sponsors of a plan, do not have to include every authorized feature in their 401(k)s, and have quite a bit of discretion in determining the details of their use. To that point, some retirement account experts are now recommending employers purposely restrict or eliminate some 401(k) features. Many of these recommendations involve loans, and while intended to improve retirement saving for participants, could perhaps have an adverse effect on employer-employee relationships.
The Leakage Problem
401(k) rules allow participants to borrow from their accounts. Under most circumstances, the amount available for loan is the lesser of 50 percent of the account balance, or $50,000. With the exception of funds used for the purchase of a first home, 401(k) loans must be repaid in five years, with payments made at least quarterly.
A loan provision is generally seen by participants as a positive feature in that a portion of their accumulation, while intended for retirement, is available today. And many participants exercise their loan privileges; a high percentage use loans to pay for current expenditures, both necessary (like medical bills) and discretionary (like vacations). This “leakage,” according to 401(k) experts, is undermining employees’ efforts to adequately save for retirement.
Their recommendation to employers? Discontinue or restrict loans, and subject would-be borrowers to screening processes. Robert Lawton, president of a retirement plan consulting firm, put it this way in a June 6, 2017, article for Employee Benefit News:
“For employers, a significant factor in helping 401(k) plan participants achieve retirement readiness is protecting them from themselves. In other words, it’s about helping participants avoid making bad decisions.”
Even though 401(k) loans are permissible, an employer is not required to make them available. And while the statutes governing plan loans place no restrictions on how funds can be used, employers can, if they choose, limit or deny loan requests based on their intended use (providing these terms apply to all participants). In effect, the employer can be a loan officer, evaluating if an employee should receive a loan—from his/her own earnings.
Some Proposed Fixes
Lawton mentions the following ways an employer can alter loan provisions to improve 401(k) plan retention: (1) Limit loans to hardship situations. Employers can require prospective borrowers to document that funds will be used to alleviate specific financial hardships, typically to pay family education expenses, to prevent eviction or foreclosure, to cover medical expenses or to buy a first-time residence. (2)Permit only one loan at a time. Instead of allowing an employee to take multiple loans as long as the total outstanding balance is below government limits, employers can decide that an existing loan must be repaid before new funds are distributed. (3) Require financial counseling. Employers can require that prospective borrowers review their loan request with HR personnel, meet with an independent financial counselor or undergo some other education or assessment before approving a loan. (4) Make only employee contributions available. In plans where the employer contributes to an employee’s account in the form of a match, all employer contributions can be excluded from consideration for loans. (5) Impose higher fees on the transaction. Lawton says higher processing fees tend to “dissuade participants from taking a loan and often reduce the amount requested.” (6) Offer employer-sponsored emergency loans. Some larger employers, such as colleges, have begun to offer short-term loans to their employees as an alternative to 401(k) borrowing. For example, the University of North Carolina offers employees with 12 months of continuous service interest-free loans up to $500. It’s not a lot, but may be enough to prevent a 401(k) loan request.
The paternal approach reflected in these suggestions may reduce 401(k) loans, but could create additional tensions in an employer-employee relationship. The financial information required by the plan sponsor to approve or decline an employee’s loan request may give management an unfair advantage in negotiating salaries and promotions. For example, if an employer knows an employee is struggling financially, and knows the reasons why, the employer might be less likely to consider the employee for promotion, even if his/her work performance is stellar.
In the past three decades, many employers have jettisoned pension plans because the long-term financial obligations were both significant and uncertain. 401(k)s, originally intended as retirement supplements, became the replacement for pensions, with all of the risk and responsibility falling to the employee. With many employees struggling as retirement planners, experts are urging employers to step in again, as financial counselors and loan officers.
A 401(k) is a deferred compensation plan. In exchange for an immediate tax advantage, participants elect to set aside a portion of today’s income, ideally until sometime after age 59½. Loan provisions may allow participants to temporarily reclaim some of their deferred income, but the terms are ultimately left to the employer’s determination. And the terms can change.
These developments might prompt employees to re-evaluate their participation in qualified plans. If loan provisions change, what is the impact on available cash reserves? Should some 401(k) contributions be allocated to other financial instruments? Is it prudent to have one’s financial condition open to employer scrutiny? These specific issues point to an essential general question:
How much money are you willing to defer until retirement if there are no options to access the money earlier?
This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
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