The ability to borrow from your 401(k) plan is thought to be one of its biggest selling points. 

And yet, this loan program holds a lot of pitfalls for participants, employer/sponsors, and trustee/fiduciaries.

For a participant, a defaulted loan brings with it an income tax on the loan balance, a 10% early distribution penalty, a depletion of his retirement savings, and a compounding loss of future earnings on the depleted savings. And for a participant whose loan is paid back by payroll withholding, these blows frequently come via job loss or layoff, when the participant can least afford the added tax burden.

For the employer/sponsor, the loan program brings added administrative costs for advising participants, issuing loans, scheduling payroll withholding repayments, and tracking and reporting defaults. Audit fees related to the plan's Form 5500 are likely to be higher to reflect added testing for loan program issues.

For employers whose plans experience higher default rates, especially plans in high-turnover industries,  I've been warning for years that plans with high default rates could face qualification issues and challenges as disguised in-service distribution programs.

Now, Bruce Ashton, with Drinker Biddle & Reath, predicts a looming threat to fiduciaries.  "Do plan sponsors have fiduciary risk when a participant defaults on his or her loan from the company’s retirement plan?" he asks.  In his article in PlanSponsor,  Participant Loans: A Fiduciary Storm Brewing? , he concludes "the short answer is likely yes."