See this year's 401(k) Special Report.

The credit crunch has come home to roost in many unlikely places, from the student-loan market to the municipal-bond arena. Here's another improbable victim: your human resources department. The subprime crisis and its many ripple effects are prompting more financially strapped homeowners to borrow from their 401(k) plans. That not only puts their long-term fiscal health in jeopardy, but also places a large burden on their employers.

"Loan programs may be the single most disliked and burdensome administrative difficulty associated with operating 401(k)s," says employee-benefits attorney Fred Reish of Reish Luftman Reicher & Cohen in Los Angeles. Too often, he says, discrepancies between the amortization schedule created for the loan and the repayment schedule created by a company's payroll vendor go undetected until a retirement plan is audited by the Internal Revenue Service, whereupon the employer must scramble to set things right. "It's a nightmare," agrees consultant Kendall Storch, director of retirement services with Boston-based Longfellow Benefits. "The tracking of the loans, the managing of the repayments, the fallout if for some reason the payments get off schedule — it all becomes a big hassle."

It's no picnic for employees, either; they face a raft of difficult calculations when deciding whether to tap a 401(k), and often don't understand the potential long-term (or even short-term) impact of such a move.

Emergency Room
Plan sponsors aren't required to offer loan programs, but a majority do. Companies routinely add a loan feature to their 401(k) plans in the belief that more employees will participate if they know they can access the funds in an emergency. But many experts say that view is misguided, and some finance chiefs agree. David Magers, executive vice president and CFO of Country Insurance & Financial Services, a privately held insurance, banking, and asset-management company, says he thinks "the defining reason employees don't sign up is cash flow. They're having trouble paying the rent."

Nonetheless, Bloomington, Illinois-based Country offers 401(k) loans because, as Magers says, "we realize there are going to be occasions when not allowing employees access to that money could put them in a position of hardship. There are times when they may need to borrow."

Hard Times
Like now, for instance. Major 401(k) providers report 13 to 19 percent jumps in loans and hardship withdrawals, with the fourth quarter of 2007 seeing a major spike in such activity. The appeal for employees is understandable, at least on the surface: you pay interest to yourself. In fact, in the first few years of this decade, when the stock market and money-market funds on average were earning 1 percent or less, an employee repaying a loan at, say, 7 percent (a typical rate is 1 percent over prime) actually earned a better rate of return than he or she might have under most other scenarios.

But far more often loans work against employees, in a number of ways. "If employees are busy paying back their loans, they can rarely also continue to contribute at their previous level," warns Jeanne Brutman, an independent financial adviser in Jackson Heights, New York. "This greatly impacts the future value of their account, as the missed contributions are not compounding over time."

Even more risky, as Richard Reyes, owner and founder of Wealth & Business Planning Group LLC in Maitland, Florida, points out, is the chance that employees won't be able to pay back their loans. When that happens, a loan becomes, in IRS lingo, a "deemed withdrawal," subject not only to ordinary income-tax rates but also, if the participant is under the age of 59 1/2, a 10 percent penalty tax.

Defaults are especially common when participants quit or lose their jobs, since 401(k) loans then become due in full — just when participants are least likely to be able to pay them back. While this termination provision is routinely spelled out in the plan's summary plan description and other documents — protecting employers from claims that it wasn't disclosed — it often catches plan participants by surprise.

Reyes recalls one highly compensated client who took out a $50,000 loan from his 401(k) plan just before unexpectedly losing his job. "He had no way to pay back the loan, so he had to pay income taxes on it at the highest marginal rate, plus a 10 percent penalty because he was under the age of 59 1/2," Reyes recalls. "He didn't have the money to pay that tax bill either, so he had to take even more money out of his IRA, and this created a snowball effect. He lost everything."

Russ MacMannis, vice president of finance for $200 million Barker Steel, in Milford, Massachusetts, says about 25 percent of the participants in his company's 401(k) plan have loans outstanding at any given time. Some are clearly struggling. "We see cases where people reduce or suspend their regular deferrals just to pay back their loans," he adds. "And we have a small group of people who never see a full paycheck except during the three-month waiting period we require between loans."

Indeed, many employers enforce a waiting period between the repayment of a loan and the resumption of regular contributions into an account, which is yet one more way that taking a loan can diminish an employee's long-term savings. Some don't allow for the simultaneous repayment of a loan and continuing contributions into an account. And, of course, employees will miss out on any employer matching contributions during periods in which they are repaying loans but not putting any "new" money into their accounts.

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