Next Employer Crackdown on 401 (k) Loans?
In an effort to educate employers on how employee 401 (k) balances are being decimated by authorizing serial loans,
How can a similarly paid employee with the same asset allocation end up with a 401 (k) worth just over a third of their colleague’s? Easy, when you can just withdraw the money. The graph shows three imaginary 55-year-old employees earning $ 100,000 per year with $ 100,000 saved so far. Their hypothetical pre-tax saving after 10 years is:
- $ 364,000 for Jen who contributed 10% of her salary and did not take out any loans or withdrawals for hardship
- $ 313,000 for Lisa who contributed 13% of her salary and took out a series of 10 loans totaling $ 117,000 while staying up to date with loan repayments
- $ 131,000 for Hugh who contributed 10% of his salary and contracted a series of hardship loans and withdrawals totaling $ 186,000.
Obviously, Jen is the winner.
Lisa came in second, having continued to contribute to the plan while the loans were in progress. And unlike many who take out loans, Lisa hasn’t lowered her deferral rate. Fidelity has found that borrowers have reduced their contributions by an average of 2 percentage points, and that it typically takes them five years to return to their old deferral rate of 6%, for example, instead of 4%. Yet even though Lisa saved 13% compared to Jane’s 10% and didn’t lower her deferral rate, she didn’t save as much as Jane – her repeated use of the loan is to blame.
Hugh is in the worst shape. He took out several loans totaling $ 126,000 and one hardship withdrawal of $ 60,000. Hardship withdrawals have a higher cost than loans because once you make a hardship withdrawal you are not allowed to contribute to your 401 (k) for six months, and you cannot pay it back. ‘money in your account (there is also a 10% penalty).
The 401 (k) borrowing is too common. Of the 12.3 million Fidelity plan employees, one in five 401 (k) plan members have an outstanding loan, and one in nine has taken out a new loan in the past year, with an average amount of $ 9,000, while 2.3% of participants took difficult withdrawals.
Fidelity has found that half of borrowers take more than one loan, and the likelihood of hardship withdrawals increases significantly among multiple borrowers (steadily rising from 6% for those who have taken out a loan to 27% for those who have contracted 7 loans). This caught the attention of employers. “Employers want to have a better idea of how important this issue is to their organization,” says Jeanne Thompson, vice president of Fidelity. “Plans that offer more than two loans ask to see if serial borrowing is a problem in the plan,” she says.
What actions could employers take? Employers can ban 401 (k) loans altogether, or they can reduce the number of authorized loans outstanding at one time. Today, about a third of plans allow only one outstanding loan at a time, 42% allow two outstanding loans at a time, and about a quarter allow more than two loans at a time.
Employers can also extend the waiting period between loans. Usually, after paying off a loan, you have to wait six months before you can take out another loan.
When it comes to hardship withdrawals, there are two different standards for deciding whether an employee request counts. The first, more restrictive standard is the Internal Revenue Service Safe Harbor standard. This includes foreclosure of your home and medical bills, the two most common reasons employees take hardship withdrawals. The other standard, which Thompson says employers might want to set aside, is a standard of facts and circumstances that is more holistic.
Automatic reinstatement of contributions after they are suspended due to a hardship withdrawal is another way employers can help employees stay on track.
What should employees do? Build an emergency savings pot outside of your 401 (k) to save for things people tend to take 401 (k) loans for, like paying for college, Thompson says. If you take out a loan, if possible, continue to put regular salary deferrals into your 401 (k) and don’t reduce the amount.