Convincing employees not to take out 401(k) loans not only benefits workers’ financial health, it also helps keep you out of the IRS crosshairs.
Reason: The greater the number of 401(k) loans and loan defaults a plan has, the greater the chances the plan has to be audited by the IRS and DOL, according to panelists presenting at the 2016 PLANSPONSOR National Conference. One of the panelists was former IRS employee-turned tax lawyer Thomas Schendt.
The audit risk is particularly high with loan defaults.
Safeguarding your plan
To prevent loan activity that may set off red flags with the feds, there are several things employers can do.
For starters, they can take some preemptive steps to prevent loans in the first place by implementing a small fee in the range of, say, $50 to $75 dollars.
Another option: Institute a limit in which the plan specifically states that employees can’t take more than one (or at most two) loans against their 401(k)s.
There are more drastic steps employers can take as well.
Employers can even prevent 401(k) defaults and plan leakage by purchasing loan protection insurance.
This type of insurance pays off the retirement loan in one lump-sum to prevent a default and covers any outstanding balance, as well as accrued interest.
One such insurance product brought up by one of the panelists is called the Retirement Loan Eraser by Custodia Financial. It gives employers the option of:
- making the insurance available to employees so they can protect themselves, or
- allowing an employer to purchase the coverage itself as a plan expense to cover all participants.
The program also offers a communication component where borrowers learn exactly how much they can lose out on in the long run by taking out a loan in the first place.