Taking a participant loan from a retirement plan is such a bad investment choice that it should not be allowed in any retirement plan other than for hardship reasons. Consider that:
- The interest on a plan loan is not tax deductible. Anyone needing a loan should investigate the possibility of taking a home equity loan first, since interest on these loans is tax deductible.
- Paying interest to yourself is not such a good idea. I have heard many participants say they believe a plan loan makes sense because they are paying interest to themselves. They often add that the higher the interest rate, the better! First, it is never a desirable financial strategy to pay interest. Second, the interest rate paid on participant loans may or may not be competitive with the rate on a home equity loan. Third, paying yourself more interest only means that you have less of a paycheck left to live on.
- Participant loans are double-taxed. This is a real killer. All participant loan payments are made using after-tax dollars and that is the first time that a participant loan balance is taxed. Assuming the loan is completely repaid, the second time the balance is taxed is when funds are removed from the retirement plan and used to fund a retirement.
- The opportunity cost can be substantial. Assume that a participant takes a $10,000 loan for 5 years at 6%. The investment experience on that portion of the participants balance will be a 6% return for 5 years. Had the loan balance been invested in the investment options in the plan for the same period of time, the participant may have earned twice as much or more!
- Many participants default on their plan loans. A large percentage of participants who take loans never pay them back. This "leakage" from their retirement accounts substantially reduces participant final balances.
- Most plan sponsors can't say no. Unless the plan has hardship provisions attached to its loan provisions, a plan sponsor cannot deny a participant loan request. This makes the retirement plan the lender of last resort and results in many bad loans being made.
It is clear that participant loans can drastically reduce an employee's chances of achieving retirement readiness. As a result, plan sponsors should seriously consider limiting loan availability to hardship criteria or eliminating loans entirely from their plans.
Contributing Editor Robert C. Lawton is President of Lawton Retirement Plan Consultants, LLC a Registered Investment Advisory firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. Mr. Lawton has over 25 years of experience working with corporations on their retirement plans and is a Chartered Retirement Plan Specialist (CRPS) and Accredited Investment Fiduciary (AIF). Mr. Lawton may be contacted at firstname.lastname@example.org 414.828.4015.
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