Including loan provisions within a 401(k) plan can be advantageous for both employers and employees. For employers, allowing participants this type of indirect access to funds can lead to fewer difficulties than the alternative of offering direct hardship distributions. Although they require detailed record keeping and must meet numerous administrative requirements, having a loan feature is popular among employees because it addresses their financial needs prior to retirement. Many factors must be considered and a thorough cost/benefit analysis is recommended when deciding whether loans should be made available to participants in the 40l(k) plan. More than half of 401(k) plans, representing 80% of 401(k) plan participants, offer a loan feature. A study by the General Accounting Office determined that a loan provision can increase employee participation. In addition, participants in 401(k) plans with loans make approximately 35% greater employee deferral contributions. At any point in time, approximately 8% of all participants have a loan outstanding.
Substantial problems occur when a loan is defaulted. Because of this, it is wise to have the loan repaid by automatically deducting the required payments from a participant's paychecks.
If a 401(k) loan provision is included, the plan service provider will frequently add a fee of up to $100 to set up the loan and an annual charge of up to $75 to administer it. These fees are frequently paid by the employee.
If loans are offered, a loan policy must be established. .A loan provision must satisfy all applicable legal requirements. These include those of the Department of Labor (D.O.L.) to avoid the loan being treated as a prohibited transaction, those of the Internal Revenue Service to avoid the loan being treated as a taxable ("deemed") distribution and those relating to general legal requirements as to what constitutes a valid loan. Loans must be available to all 401(k) participants on a reasonably equivalent basis and meet strict requirements, including:
1. "Highly compensated employees" must not be favored over non-highly compensated employees.
2. Loans must bear a reasonable rate of interest
3. They must be satisfactorily secured.
4. They must be consistent with plan provisions.
5. The amount of a loan (assuming no prior loan was outstanding one year previously) must be limited to the lesser of 50% of the present value of the employee's vested account balance in the plan or $50,000.
6. The loan must be repaid over 5 years (up to 15 years is allowed if the loan is used to purchase a participant's principal residence).