June 22, 2011

Like all tax-deferred retirement accounts, 401(k)s exist to incent individuals to save for retirement. Given the state of our nation’s entitlement programs, it is more important than ever to invest the absolute maximum possible in defined contribution, tax advantaged accounts like 401(k)s and IRAs. Funding these accounts, however, is only half the battle. The other half consists of growing the balance in these accounts by keeping the money there and investing it wisely. As millions of families face financial challenges, they have tapped their retirement accounts for cash to pay for basic living expenses. A common way to do this is by taking out a loan against your 401(k).

401(k) loans are too popular and the majority have a loan provision. This permits the account owner to take money out of the account in the form of a loan without incurring penalties. If you do take out a 401(k) loan, you have to pay it back with interest. Approximately one third of 401(k) account owners with a loan provision currently have a loan outstanding.

Many people use these loans because they have no other choice. Others do so because the cost of a 401(k) loan can be far less than other alternatives. Even if it is the most attractive option, there are costs and risks. Many plans do not allow you to make further contributions until the loan is repaid in full.  These people miss out on employer matching, which is basically free money. They also miss out on the opportunity of having that money grow in a tax-deferred manner.

Democrat Senator Herb Kohl of Wisconsin and Republican Senator Mike Enzi of Wyoming recently introduced the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011, or SEAL Act. Beyond having a clever acronym, the bill would change certain aspects of 401(k) loans if enacted as proposed. Currently, a plan owner can have many loans outstanding. This is common especially if the loan proceeds are being used to offset unforeseen expenses. The law would limit the total number of concurrent 401(k) loans to three at a time.

The law would also ban any financial product that promotes or encourages 401(k) loans. A common example is the “401(k) debit card” which is linked directly to the account. This isn’t the first attempt at banning these products, but support among elected officials is more prevalent today.

Some provisions will help consumers. For “hardship” 401(k) loans, account owners will be allowed to make contributions during the first six months after the withdrawal. This allows the owner to capture employer matching on those deposits, reducing significantly the “opportunity cost” of a 401(k) loan.

As a small business owner, this legislation could have a significant impact on your workforce. Employees that may require a 401(k) loan to make ends meet could be forced to find other work or take on a second job. The stress from the personal financial problems they face will also hurt productivity. They may look to you to “make them whole” in some other fashion. It’s important that you be prepared to face the challenges that this legislation will create within a segment of your workforce.

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