The importance of offering 401(k) loans with guardrails

Impact of 401(k) plan loans on financial well-being

Participants with outstanding loans tend to feel less optimistic about their financial picture and retirement than those who haven’t borrowed from their accounts. 

These figures underscore the importance of responsible borrowing—and that’s where your plan’s loan policy may come in. 

Overview of DOL and IRS 401(k) participant loan guidelines

To set the stage, let’s first review the DOL and IRS rules,³ which provide the foundation for your loan policy. 

• If you want to offer loans, this feature must be specified in your plan document and be available to all eligible employees.
• You must charge a reasonable rate of interest, which is typically prime rate plus one or two percentage points.
• The most participants can borrow is the lesser of 50% of their vested account balance or $50,000.
• Loans have to be repaid within five years, except for the purchase of a primary residence.
• Repayments must be made at least quarterly and be substantially level amounts.

Designing your 401(k) plan loan provisions

Within this framework, you have the flexibility to customize your loan features based on your plan’s specific needs and objectives. You can use this flexibility to send a message to your participants about borrowing from their accounts. What’s the message? That loans should be used for immediate and unforeseen financial expenses—and not as a quick source of cash. So, as you review or create your loan policy, consider:

1 The number of loans—Allowing participants to have multiple outstanding loans may encourage excessive borrowing, potentially putting their retirement further out of reach. For this reason, approximately 63% of 401(k) plans only permit one outstanding loan at a time.¹

2 Contribution source—You may want to limit borrowing to just employee deferrals. This way, any employer matching and profit sharing contributions can continue to help participants build their retirement savings.

3 Loan amount—The IRS’s maximum loan amount is just that—a maximum. You can choose any percentage or dollar amount you want as long as they don’t exceed the limit. For example, you might allow participants to only borrow 30% of their vested account balance up to $35,000. Sixty-two percent of plan sponsors¹ have set a lower limit to help participants keep more of their money in their account.       

4 Purpose—Similarly, you may want to limit the reasons participants can request a loan. Having no restrictions makes it easier for participants to borrow for nonessential purposes such as a vacation.     

5 Fees—Assessing a loan origination fee can serve as a deterrent and prompt participants to carefully evaluate their need for a loan. Roughly 40% of 401(k) plans charge a loan origination fee of $100 or more.¹

Keep in mind that these guardrails may increase the complexity of your plan’s administration. So make sure you involve your plan’s financial professional, recordkeeper, and third-party administrator in the discussion.  

Educating your participants about 401(k) loans

Using guardrails to help limit borrowing can be a good first step. But it’s also important to educate participants about 401(k) loans, including:

• How they work
• The potential impact on retirement savings
• The potential tax consequences if they aren’t repaid
• Alternatives to borrowing from their account
• Available tools and resources to help them make an informed decision

It’s through effective 401(k) plan loan design and education that you can encourage participants to use their retirement accounts for their intended purpose—retirement.

1 “2024 PLANSPONSOR Defined Contribution Plan Industry Report: 401(k) Plans,” Asset International, a division of ISS STOXX, © 1989–2024. 2 In June 2024, John Hancock commissioned our 10^th annual financial resilience and longevity survey with the respected research firm Edelman Public Relations Worldwide Canada (Edelman). An online survey of 2,623 John Hancock plan participants was conducted between 5/17/24 and 6/3/24 and 525 retired Americans, sourced through Angus Reid’s research panel, was conducted between 5/13/24 and 5/28/24. The objectives of the study were to learn more about individual stress levels, their causes and effects, strategies for relief, and to provide custom insight around how retirees are faring in retirement. John Hancock and Edelman are not affiliated, and neither is responsible for the liabilities of the other. 3 "401(k) resource guide - plan sponsors - general distribution rules," irs.gov, 11/15/24.