401(k) loans: An essential guide for employers and plan sponsors

As a 401(k) plan sponsor, you’re likely facing a lot of important decisions. One of those key decisions is whether or not to offer 401(k) loans. Not all plans offer loans, because not all plan sponsors choose to do so.

It's important to consider the benefits and challenges of offering 401(k) loans when deciding if you will offer them. Some plan sponsors wish to offer loans because their employees like the flexibility they can offer, especially younger employees who may be wary of having money "locked up" in a retirement account.

Other plan sponsors refrain from offering loans because of the recordkeeping complexities and because they may put employees at risk of defaulting and damaging their retirement savings. Ultimately, it's important to understand 401(k) loans in-depth so you can make an informed decision that is right for your company.

What is a 401(k) loan?

A 401(k) loan is a loan in which an eligible employee borrows against the funds in their 401(k). The IRS and the Department of Labor both have 401(k) loan rules that plan sponsors and employees have to follow.

A 401(k) loan typically has a relatively low interest rate compared to unsecured personal loans, and borrowers generally have up to five years to repay it. However, as an employer, you can set additional rules or requirements. Also, some employers may choose to not allow 401(k) loans at all.

How does a 401(k) loan work?

A 401(k) loan works differently from other loans because the borrower isn't borrowing money from a lender. Instead, the borrower borrows against their 401(k) balance without the burden of an early withdrawal penalty, provided all loan rules are followed. Then the borrower will return the money to their account with interest.

If your 401(k) plan allows 401(k) loans, employees can request a loan. Once the loan is approved, some of their investments will be sold, and they’ll receive the cash. They then have to repay the loan based on the loan agreement. They must repay the loan within five years (unless they use the money to purchase a primary residence).

What if your employee quits or gets let go? It’s important for them to know that their repayment schedule could be accelerated in this case. If they do not repay the loan by the deadline set by the plan’s loan policy, they may be able to rollover the loan amount to an IRA or other qualified retirement plan.

If an employee falls behind on their loan payments, the loan could be considered a taxable distribution. In that case, they may have to pay income taxes and an early withdrawal penalty unless a penalty exception applies.

Types of 401(k) loans

There are two major categories of 401(k) loans:

401(k) general purpose loans

For a 401(k) general-purpose loan, borrowers can typically use the money they borrow for whatever they like. That’s why it is considered “general-purpose.” While the plan’s loan policy can limit the reasons for taking a loan (e.g. only if the participant meets the requirements to take a safe harbor hardship distribution) care must be taken to ensure that loans are available to all participants on an equivalent basis. Generally, the application process doesn't require the employee to specify the reason for the loan or their plans for the money. The maximum repayment period for a general-purpose loan is five years.

401(k) residential loans

On the other hand, with a 401(k) residential loan, borrowers can only use the money to purchase a primary residence. For this kind of loan, employees must submit supporting documents, such as a purchase and sales agreement. Residential loans often provide longer repayment terms compared to general-purpose loans but must be limited to what a reasonable mortgage length would be.

What’s the difference between a 401(k) loan and hardship withdrawal?

A hardship withdrawal is a one-time withdrawal of funds that an employee may be able to take if they experience extreme financial hardship. Of course, the IRS has some specific rules for what that hardship looks like and what the money can be used for. In general, these qualified expenses include certain medical expenses, principal residence purchase (excluding mortgage), tuition-related costs, payments to prevent eviction, burial or funeral expenses, casualty deduction costs for primary residence, and certain emergency repairs to primary residence. With a hardship withdrawal, the money is not paid back or replaced and cannot be rolled over to an IRA or other retirement plan.

A 401(k) loan is different because it is a loan; it must be repaid. Additionally, employees can generally use a 401(k) loan for whatever they please, not just specific expenses.

401(k) loan guidelines for employers

As a plan sponsor, here are some important guidelines you should know about 401(k) loans:

Understand 401(k) loan limits

Both the IRS and the Department of Labor have rules around how much employees can borrow with a 401(k) loan. The IRS allows eligible employees to borrow up to 50% of their vested 401(k) retirement savings, with a $50,000 cap. The Department of Labor also limits the maximum amount that an employee can borrow. Taking into account both sets of rules, the formula for determining the maximum loan one can take is the lesser of:

As a plan sponsor, you will also be called upon to set some limits for the 401(k) loans you offer. These include interest rate, acceptable repayment schedule, maximum loan terms, and more. While your loan policy can be changed at any time, those changes would not apply to existing loans. So it’s important to figure out what will work best for your organization up front, to hopefully avoid any big changes down the line.

Set an interest rate

As the plan sponsor, it’s up to you to decide the interest rate for your 401(k) loan offering. The IRS does mandate that 401(k) loans must be secured and the interest rate and repayment schedule you choose must be “commercially reasonable.” So you can’t offer something that is worse than a rate your employee could get from another lender on the market for the same type of loan.

Create a repayment plan

Just like setting an interest rate, you must set a reasonable repayment plan. For general-purpose 401(k) loans, the maximum amount of time for repayment is five years (though it can be longer for residential loans). Your employees must make equal repayments, so no balloon payments or payments that increase over time. Repayments must include both interest and principal payments each time, and they have to be made at least quarterly.

Provide proper documentation

As you probably know by now, as a plan sponsor there is a lot of reporting, paperwork, and documentation to keep track of. When it comes to 401(k) loans, there are a few important pieces of info you must keep track of and report accurately for each loan. These include:

Common pitfalls of 401(k) loans

While there are many employers who choose to offer 401(k) loans, they do have some pitfalls that can cause you headaches if you don’t stay on top of them:

Loans exceeding the maximum amount

Employees cannot take out a loan that exceeds the maximum dollar amount they are allowed. If you, as a plan sponsor, approve a loan that is too much, your employee could end up in a tight spot.

What’s the fix?

The borrower can make a lump sum repayment of the amount over the limit.

Loans with payment schedules that don't meet time limits

Employees cannot take longer than five years to repay a general purpose 401(k) loan.

What’s the fix?

The borrower can make a lump sum repayment of the amount still left up until the last day of the loan term.

Defaulted loans

Employees cannot miss payments as they repay their loan.

What’s the fix?

The borrower can catch up on missed payments by the end of the “cure period,” a sort of grace period during which payments can still be made. If it is beyond the cure period, then any missed payments would be deemed a distribution.

Employee leaves the organization

When an employee quits or is let go, the loan policy can require that they repay the balance on any outstanding 401(k) loan.

What’s the fix?

The borrower can make a lump sum repayment or if both plan’s allow they can roll over their loan to an eligible retirement plan. If they are unable to do either and the loan is offset the participant may be eligible to rollover the loan amount.

How to correct issues with 401(k) loans

The allowable correction method will depend on the type of issue and what you as the plan sponsor allow. Per the IRS, “If participant loans under your plan do not meet the legal requirements, or if repayments have not been made according to the schedule set out in the loan document, you may be able to correct these problems using the Voluntary Correction Program. The program allows you to repay loans over the remaining loan period or report past-due loans as distributions in the year of the correction.” So luckily, there are remedies if issues happen with 401(k) loans your organization offers.

Why should I offer 401(k) loans?

Many plan sponsors offer 401(k) loans as a perk to their employees, be it to help drive plan participation or because they simply know employees may want to take advantage of them. Some employees may not want to enroll in a retirement plan and set aside money if they think they can’t easily access it in case of an emergency or life-changing event. By allowing loans, employees can have more peace of mind that they’ll be able to use the funds if they need to.

If you choose to offer 401(k) loans, here are a few best practices to keep in mind:

Being a plan sponsor comes with a lot of responsibilities. But with the right education (and expert knowledge from your advisors!), you can create and offer a retirement plan that your employees love.