If you have wondered whether to allow participants to take loans from their retirement plans, you’re likely not alone. On the face of it, allowing loans is a good thing because it encourages younger employees to participate in the plan when otherwise they might be afraid to tie up their assets for 30 to 40 years. Loans offer them the hope of having a tax-free access to their account should an emergency arise.
But we all know the reality of plan loans is very different. Some participants treat the loan program as a revolving source of credit, taking a new loan as soon as the old one is paid off. In plans that allow it, some participants juggle two, three…up to five different loans, all at the same time. All those loan repayments keep a participant from boosting their savings and can have a significant impact on how much they have available at retirement.
Although there are many abuses involving plan loans, there is still a valid reason to offer no more than two loans – as long as participants are made aware of all the consequences. The first is the double taxation on loan interest. When you take a plan loan, you do not pay taxes on the principal as long as you repay within the allotted time. Although you use after-tax income to repay the principal, you took out pre-tax money and were never taxed, so there is no double taxation. However, the interest that you pay enters the plan as after-tax money but it is taxed again upon at retirement, resulting in double taxation.
The second consequence for employees to consider is leaving their job when they still have an outstanding loan. Most retirement plans require that a loan balance be immediately paid off upon termination, otherwise the balance will be treated as a taxable distribution and the participant may be subject to a penalty if they are less than age 59 ½.
So, when was the last time your company updated their loan policy and communication strategy?
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advisory services offered through Global Retirement Partners, LLC, a registered investment advisor. Global Retirement Partners, LLC, Frenkel Benefits, LLC, and LPL Financial are separate and non-affiliated companies.
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