The Loan Danger

All of this comes at a time when 401(k) plans face an additional form of peril: stagnation. According to Deloitte, after years of strong growth, participation in 401(k)s appears to be "topping out." For example, in 2000 there were approximately 687,000 defined-contribution plans in the United States. By 2004 that number had actually dropped by about 50,000. Meanwhile, 52.9 million employees participated in such plans in 2002, a number that dropped by 700,000 participants two years later. Add to that anecdotal evidence that many workers lack the financial literacy to understand simple concepts like the effects of compound interest (in a recent Journal of Monetary Economics article it was noted that only 18 percent of adults could answer a simple question regarding how much $200 in a savings account would be worth two years later if the account paid 10 percent per year), and it seems that 401(k) account management is something many workers struggle with.

What to Do
Given all that, it's not surprising that Reish advises employers not to offer loan programs unless they truly deem it necessary to get employees to participate in their 401(k) plans. Employers who do offer loans can take measures to minimize both the administrative pain that such programs generate and the potential for abuse by employees.

• First, limit participants to one loan at a time. "We used to allow two loans, and it was just exponentially more difficult to administer," observes MacMannis. "You have to keep track of which payment is for which loan. We also found that it was really being abused by employees."

• Next, require that participants wait some period of time after paying off a loan — say, six months — before allowing them to take out another one. Otherwise, loans can become a permanent crutch. "We absolutely have clients where people use the loan program like a revolving door," says Storch. "It defeats the whole purpose of having a retirement savings plan."

• In extreme cases, employers can allow loans only for the same limited reasons the IRS allows hardship withdrawals from 401(k) accounts, such as to pay for un-reimbursed medical expenses or to prevent the loss of a home (see "Hardship Withdrawals" at the end of this article). And, even though employees are paying interest to themselves, setting the rates higher may prompt some to explore the options at their local bank or credit union.

Finally, employers can do more to educate employees about the potential hazards of taking money out of their retirement plans, from the tax bite to the payback provisions to the long-term impact it can have on the size of their retirement nest egg (see "The Price You Pay" at the end of this article). Companies devote plenty of time and energy to encouraging employees to join 401(k) plans; they would do well to devote just as much to explaining why it's important to stay in, and why loans so often amount to getting out.

Randy Myers is a contributing editor of CFO.

Hardship Withdrawals

Loans are one way that participants in 401(k) plans can take money from their retirement accounts before retiring. The other is through a hardship withdrawal. Unlike loans, hardship withdrawals need not be paid back. However, they can have onerous tax consequences. Except in very limited circumstances, they are taxed at ordinary income rates, and, if the participant is under the age of 59 1/2, they also carry a 10 percent penalty tax. The Internal Revenue Service allows hardship withdrawals only for very specific reasons: to cover un-reimbursed medical expenses, to purchase or repair a primary residence, to avoid eviction from or foreclosure on an existing residence, to pay for tuition or related educational costs, or to pay for a funeral.

Employers aren't required to offer hardship withdrawals, but most do. Country Insurance & Financial Services has managed to keep them to a minimum, however, in part by requiring that before participants take a withdrawal they first exhaust their loan limits, which the IRS sets at 50 percent of an account balance up to a maximum of $50,000. While its 401(k) plan has approximately 4,300 participants, Country processes only about five hardship withdrawals per year, says CFO David Magers. By contrast, about 600 participants have loans outstanding at any one time. — R.M.

• « previous
• 1
• 2