Many 401(k) plans allow participants to take out loans from their individual 401(k) account. According to Employee Benefits Survey: 2024 Results, 81% of corporate employer plans offered a 401(k) loan provision. While loan options provide flexibility for those hesitant to contribute to 401(k) accounts, the option to borrow can also have a negative impact on retirement security when the loan isn’t repaid.

Considering loan options for your 401(k) plan but concerned about the potential consequences? The following are plan design ideas for plan sponsors that want to allow employees to borrow against 401(k) accounts and, at the same time, ensure that the loan is repaid as well as add some retirement security protections.

First, some background on 401(k) loan defaults.

When 401(k) borrowers quit or lose their job

An employee with an outstanding 401(k) loan who quits or loses their job generally has two, possibly three options: (1) Pay back the loan in full within 60 days, or (2) “default,” meaning fail to repay the loan and treat it as a distribution. (3) Plans may allow a third option which is to continue loan repayment after leaving the company. According to Vanguard’s How America Saves, 40% of plans permit terminated participants to continue loan repayment.

What percentage of 401(k) loans default?

Recordkeeper data shows a range, but generally under 10% of 401(k) loans default. An annual report that tracks loan behavior, Reference Point from T. Rowe Price, reported that although loan rates increased in 2023, loan defaults declined for the third year in a row. In 2023, 9.5% of loans defaulted, bringing it back to the 2020 level of 9.5%, according to T. Rowe Price data.

According to Principal data, only 1.5% of those participants with loans left their employer with an outstanding balance in 2022.

401(k) loan program design tips

By including a loan option, your employees may perceive the plan design as a suggestion to use 401(k) assets for nonretirement reasons, known as the endorsement effect. These design tips are intended to provide participant education, avoid the endorsement effect, lower the balance of outstanding loans and prevent loan defaults, regardless of employees’ job stability.

Avoid the endorsement effect

1. Permit only one outstanding loan at a time.
2. Limit loan access to only employee contributions.
3. Limit the dollar amount or percent of vested balance available.
4. Limit acceptable reasons for seeking the loan.
5. Set a minimum loan amount of $1,000. This shows that the 401(k) plan is not a form of revolving credit and discourages frivolous use.
6. Add or increase waiting periods. Plans can have a delay period after a loan payoff and before a participant can apply for a new loan. If the plan allows more than one loan, there can be a waiting period before another loan is permitted.
7. Add or increase fees. Plans with higher loan origination fees have smaller outstanding balances according to Aon Hewitt’s 2013 report, Minimizing Defined Contribution Plan Loan Leakage. Loan origination and maintenance fees are increasing. With loan fees, sponsors can allocate costs directly to those participants incurring loan-related expenses, per Vanguard’s 2024 report.

Communicate required information

8. To receive a plan loan, a participant must apply for the loan and the loan must meet certain tax law requirements. The participant should receive information from the plan administrator describing the availability of and terms for obtaining a loan. The participant should also receive an application and/or instructions for how to apply for the loan. This engagement with the participant is a prime opportunity to provide education and decision support.
9. The Internal Revenue Service (IRS) lists the following information that the participant should receive before applying for a 401(k) loan.
   • Whether loans are/are not permitted
   • Minimum dollar amount required to obtain a loan
   • Maximum dollar amount permitted
   • Maximum number of loans permitted by the plan
   • Term of repayment
   • How repayment may be made
   • Fees
   • Interest rate
   • Security for the loan
   • Spousal consent requirements.
10. Explain the consequences of changing jobs with a loan outstanding (i.e., loan comes immediately due) and whether the plan allows repayment to continue after employment is terminated.
11. Further explain the interest rate in repayment. Sometimes the repayment interest rate will be higher than what the account investments earn. Typically, any interest earned is attributed to the participant’s account. The most prevalent interest rate was prime plus 1% in Vanguard’s report.

Use behavioral economics techniques

12. Prompt your employee to visualize where they see themselves five years in the future. We all tend to “discount” things that will happen far in the future as being less important than today’s needs.
13. To confirm understanding that repayment is mandatory, have participants execute loan agreements as the borrower and as the lender (their future self).
14. Describe how repayment might feel and its impact on cash flow. Participants get the loan funds upfront, but then they will be taking a pay cut until the loan is repaid with interest. Explain that they’re essentially taking a pay cut from future paychecks to repay interest to themselves. Most 401(k) plan recordkeepers or administrators have plan loan calculators for participants to see what that repayment “pay cut” looks like for various amounts and years of repayment.

Protect savings

15. Plans can automatically continue an employee’s contribution rate during repayment. New research shows that most participants understand that loan repayments are not plan contributions. Using data from Vanguard 401(k) plans, authors of a new working paper “establish a new empirical fact: retirement plan contributions are remarkably stable after loans and hardship withdrawals. Relative to a control group, loan takers’ contribution rates fall by just 0.8 percentage points in the two years following loan issuance, despite simultaneously making large loan repayments,” authors John Beshears, James J. Choi, Joel Dickson, Aaron Goodman, Fiona Greig and David I. Laibson stated in “Does 401(k) Loan Repayment Crowd Out Retirement Saving? Implications for Plan Design,” published October 3, 2024 (Wharton Pension Research Council Working Paper No. 2024-22 available at SSRN).

Allow repayment after termination

16. Plans that allow repayment after termination should consider obtaining commitment, including an authorized automatic repayment from bank account and a written agreement to repay the loan, regardless of continued employment.
17. Simplify repayment by setting up direct debit from a personal bank account instead of payment set up as payroll deduction. If the employee changes jobs, then the loan repayments can continue, like automatic bill-pay. This helps prevent defaults.

Plan sponsors can consider these plan design ideas to help participants make informed decisions about borrowing from their 401(k) as well as (if they do take out a loan) to help ensure they repay the full amount and continue regular contributions to their retirement plan.

Developed by International Foundation Information Center staff. This does not constitute legal advice. Please consult your plan professionals for legal advice.