As the weather heated up this summer, so too did the discussion on participant loans from defined contribution (DC) plans. At least a handful of financial news sites have published pieces critical of participant loans.
With information often comes misinformation and, accordingly, some clearing up is in order. Here are a few recently heard statements—in both pro-loan and anti-loan flavors, culled from participants and analysts alike—and the facts behind them.
“Since I’m borrowing from myself and paying interest to myself, taking a plan loan is actually good for my 401(k).”
Generally false. It is definitely true that, in and of itself, paying interest to yourself is better than paying it to another entity, such as a bank. Fees associated with plan loans also are often lower than those at commercial lending institutions (although those fees vary widely).
Other than the loan fee, the loan cost is the loss of the earnings of those funds if they had remained invested in the plan during the time of repayment. If by chance the market declines while the loan balance is out of the plan, the participant would have been fortunate to have taken a loan at that time. However, the reason participants choose to invest in the first place is that, on average, earnings are positive. Chances are, therefore, that the account will miss out on additional earnings during the time those funds are out as a loan rather than invested.
“Aren’t my loan payments double-taxed? The payments are taxed—and then I get taxed again when I cash out the account.”
Mostly false. This persistent (and sensible sounding) myth asserts that the participant makes loan payments with after-tax money, and the funds are taxed again upon eventual distribution. That assertion overlooks the fact that the loan funds were not taxed when disbursed. The net effect, therefore, is that “it all evens out”: with single taxation each on the funds received via loan disbursement, and on the tax-deferred contributions upon distribution of them. The interest payments, however, are double-taxed—unless distributed tax-free from a Roth account—because, unlike the loan proceeds, the participant never received the interest portion tax-free.
“You should take any other credit available to you before taking a 401(k) loan.”
Probably false, because there are a lot worse ways participants can borrow. When plan loans are offered, they must be at commercially reasonable rates of interest, and they must be the same for all plan participants. For participants without many options, therefore, plan loans might be the only accessible route to decent credit. Payday loans, credit cards, and high-interest personal loans, for example, all may be far more dangerous to long-term financial security than plan loans.
“Plans should get rid of loans, since they prevent participants from amassing retirement savings.”
Not necessarily. Plan sponsors should consider more than whether, all else being equal, participants will have less in their retirement accounts if they take a couple plan loans over the course of employment. While the answer to that is almost certainly yes, in reality all else is rarely equal. Participants may turn to withdrawals if loans are not available. Many may be more reluctant to participate at all—or may make very conservative estimates on how much they can afford to save—if they know the funds are firmly off-limits until termination or attainment of a certain age. The fear of saving in the first place may impact retirement readiness just as easily as tapping into what’s already there.
Sponsors (in collaboration with their consultants or service providers) should consider turning first to participant education and certain loan conditions that may make sense for their participant groups, before making hasty decisions to end or curtail their loan programs.