The problem with loans

When I draft a new 401(k) plan for a client, I’ll recommend a loan provision even though it can be an administrative headache. The reason that I add it is because I think participants need to have access to money if in their account if they need it.

However, there are some things that I put in place to take away some of the headaches. I always require a $1,000 minimum for loans, there is no reason a participant should take out a loan for $250 especially when the loan fee charged to their account is going to be $50 or $75. In general, you want it for people who need money and de minimis amounts aren’t going to meet that need.

I also like to have one loan outstanding at a time. I’ve seen plans where participants have 8-9 loans outstanding and it can be an administrative headache to make sure all of them are paid on time.

Even with these provisions, they often become a headache especially when payroll mistakes fail to pay off a loan and you may have a prohibited transaction on the books if quarterly payments weren’t made on the loan. There is nothing worse than to hand a participant a 1099 because you failed to make sure payroll pay off their outstanding loan.

They’re also a headache in the sense that most errors dealing with loans only get discovered on a government audit or when there is a change of third-party administrator. That means errors are discovered years after they take place, creating a migraine or a headache if you’re the plan sponsor that has to fix it.

So while you may want loans in your plan, be cautious in its operation.

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