Qualified 401(k) plans may---but are not required to---allow plan participants to borrow against their 401(k) accounts. Two commons reasons for 401(k) loans, for example, are that participants need short-term liquidity or that they need funds to purchase a house.
But as a 401(k) plan administrator, what are the pros and cons of allowing such loans?
401(k) loans have maximum limits. One such limitation is set at the Federal level. No 401(k) loan can surpass the greater of 1) $50,000 or 2) 50% of the 401(k) account balance.
Quick math shows us that 401(k) accounts below $100,000 are capped by the 50% limit, whereas the $50,000 loan limit restricts 401(k) accounts above $100,000.
But individual plans may choose to enact lower maximums on loans allowed by their plans. Additionally, some 401(k) plans choose to enact minimums on their loans. For example, the paperwork and administrative costs of organizing a $100 loan might not be worthwhile. This is why minimums might make sense for you.
Restricting Loans - Pros and Cons
Let's examine some side effects---both good and bad---of restricting the number or size of loans within a 401(k) plan.
Pro - On average, restricting loans can do your participants a favor by maximizing their long-term success.
Let's put it another way. 401(k) loans have the potential to hurt--by borrowing against one's retirement--more than they help--by providing immediate liquidity to the plan participant. Placing restrictions on the size of 401(k) loans can help your participants in the long run by preventing them from taking large loans against their long-term best interest.
Pro - Restricting the number of loans helps keep money in the plan. Plans with more participants and higher assets under management tend to receive lower fee thresholds. Therefore, more money in the plan helps all plan participants by keeping fees lower, on average.
Pro – Loans can often become an administrative burden on HR and/or payroll. In retirement plans with unlimited number of available loans, the process of approving, adding into the payroll system, and re-amortizing for leave, absence, or changes to pay can be tedious and time consuming.
Con - The participants of a 401(k) plan might expect flexibility within the plan. Restricting the number of loans removes that flexibility. This might make your 401(k) plan appear less competitive against a peer plan in terms of "bells and whistles."
Participants might stay away or contribute less as a result. If participants know that they cannot take a loan when they need it, they’ll keep their money in a more liquid investment or account.
Con - Let's be honest: people rarely enjoy feeling like "the man" is holding them down. When participants find out that Federal law allows them to take 401(k) loans, but that their own plan prevents them from doing so, they may view that negatively.
Con – There is always potential that an employee is in dire need of the funds and unable to access them via loan. Most employers would prefer that their employees have access in case of emergency but restricted in cases of frivolous loan requests. The broad restriction of number or size of loans cannot account for all individual situations.
Placing restrictions on 401(k) loans in your plan can have both positive and negative effects.
The positive effects are primarily fiscal. Keeping more money in the plan is better for all participants in the plan and is frequently better for the potential loanee.
The negative effect of restrictions is that they're restricting! The restrictive plan could look less competitive, dampen participation in the first place, and harbor ill-will against the restrictive plan.
Understanding these pros and cons---and how your plan's participants might feel about 401(k) loans---is vital before making big decisions regarding 401(k) loan restrictions.