The Costs and Benefits of a 401(K) Plan Offering Loans to Employees

When launching a qualified retirement plan for employees, a key decision plan sponsors must make is whether to offer the option for employees to take out loans from their plan balance. There are a few key pros and cons about plan loans that I think are worth exploring.

The first hesitation about 401(K) loans that plan sponsors may have is that employees will recklessly take out loans from their accounts. Employees may use this quick access to cash to fund needless luxury purchases or even treat it as an extra line of credit. The truth is that most 401(K) loans are used to pay off debt or fund essential expenses like housing, food, or medical expenses*. 401(K) loans may be especially beneficial today as recent inflation has made these essentials less affordable.

Another top-of-mind concern is that borrowers may leave the company and default on outstanding loans. Younger and lower income employees may take out a loan without properly weighing the pros and cons of doing so and eventually leave the company, thereby defaulting on the loan if not repaid (which is treated as a retirement account distribution and may carry a large tax consequence). In reality, the data shows that those taking loans are typically more tenured and only a small portion of borrowers will leave with outstanding loan balances*.

Finally, plan sponsors should weigh the additional administrative complexity that may come with offering 401(K) loans to participants. This is indeed another cost that must be factored into this plan design decision.

While it is very prudent to consider the potential costs of offering loans in a 401(K) plan, many of these risks have been overstated. Offering 401(K) loans may boost participation in your qualified plan and drive better retirement outcomes for participants. The availability of loans from these accounts can provide significant peace of mind to participants deciding whether to save for retirement through your company’s 401(K) plan.

*Source: Principal® Retirement Security Survey

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