401(k) Debit Cards—Think Before You Swipe
Many Americans tap their retirement savings before they retire, potentially harming their efforts to provide for a financially secure future. With the advent of the 401(k) debit card, borrowing from a retirement savings account is as easy as swiping and spending. These cards are often marketed as ideal for employers whose workforce include young, seasonal, transitory or union workers.
FINRA is issuing this Alert to inform investors about the potential pitfalls of 401(k) debit cards. Although they may seem to be an attractive feature of some 401(k) plans, taking money out of your retirement savings, even for a short period of time, can have enormous repercussions for your retirement security—particularly if you never put the money back.
How Does the 401(k) Debit Card Work?
A 401(k) debit card is like a debit and credit card rolled into one. It acts like a debit card because it allows you to access and spend your own money, rather than someone else's. It also acts like a credit card because you can repay your balance over time, and you pay interest and fees on the money you spend.
When you use a 401(k) debit card, you are borrowing from your 401(k) account. If your plan allows these cards and you choose to use this feature, your employer must first approve the amount you may borrow based on how much you've saved for retirement. That approved amount of funds is set aside in a separate money market fund and will generally earn dividends on a tax-deferred basis until you use the debit card or write a check against the account. Your returns in this account may or may not be as high as those that your other 401(k) assets could earn. For example, between the years 1926 and 2007, U.S. large cap stocks on the whole earned an annual average return of 10.4 percent, whereas money market funds earned 3.7 percent.
You don't need separate approval for each transaction. The total amount that you borrow each day, whether by swiping your card or writing checks, is aggregated and counts as a single loan. This means you could have multiple loans, each with a different repayment term. Generally the amount of total borrowing may not exceed the amount that has been approved. If it does, your employer may impose a penalty or may approve the additional amount—it depends on the employer's plan guidelines.
You can be approved for a revolving line—like a credit line—meaning that your payments are added back to the total amount approved and can be borrowed again. Or your employer may only allow a non-revolving line, which means that you won't be able to borrow back the funds you've repaid unless you get approval for a new loan amount.
Interest and Fees Can Add Up
You are billed each month for the charges you ring up, plus interest and fees. Interest starts accruing as soon as a transaction is posted to your account—there is no grace period, as there is with some credit cards.
Interest rates generally are tied to the "prime rate" as with traditional credit cards. The 401(k) debit card also carries an additional charge based on the amount you borrow (referred to as a "margin") that is paid to the debit card vendor. Your human resources or benefits department should be able to help you find out the interest rate on your loan, including the margin that goes to the debit card vendor. A minimum payment is due each billing cycle and finance charges continue until the amount you have borrowed is paid back in full.
In addition to finance charges, there are fees associated with the 401(k) debit card:
- There may be a set up fee and an annual fee associated with your card;
- A cash advance fee (currently $2.00) is charged every time you use the debit card to obtain cash at an ATM or bank, regardless of which ATM or bank you use; and
- Return payment fees and fees for express delivery services can also apply.
Be sure to read your disclosure documents to make sure you understand all the fees, as well as the other conditions associated with your card.
As with a traditional 401(k) loan, the money that you borrow using a 401(k) debit card must comply with IRS restrictions and other terms that your employer may put in place. The maximum amount you may borrow from your 401(k) under IRS rules is generally $50,000 or 50 percent of your vested account balance, whichever is less. This amount is reduced if you have or had an outstanding loan balance during the one-year period before the new loan. Your employer may further limit this amount or place other restrictions on borrowing. In addition, if you're married, your spouse must consent to your debit card arrangement.
Pay Yourself Back!
As with a traditional 401(k) loan, each loan made with your 401(k) debit card generally must be paid back in five years or less. If you're using the money to buy your primary residence, your plan may allow for a longer repayment period. You must also make regular payments that include both interest and principal at least every three months.
If you do not pay your loan back in time—or fail to make payments for three consecutive months—your loan will be considered to be in default and treated as a 401(k) distribution. This means that you'll have to pay taxes on your loan balance and, unless you're already 59½ or older, you'll owe a 10 percent penalty as well.
In a more traditional 401(k) loan, the interest you pay goes right back into your 401(k) account and can come straight from your pay through payroll deduction. This way you are less likely to fall behind as long as you are employed. With a 401(k) debit card, however, payroll deduction is not currently available. It's like your other bills—you must repay yourself using checks, automatic transfers from a bank account of your choosing, or wire transfers. Also, only part of your interest goes back into your 401(k) account—the remainder goes to the debit card vendor.
Weighing the Pros and Cons
Using a 401(k) debit card to borrow from your 401(k) may offer some advantages over other types of loans:
- You can use the funds for any purpose and usually don't have to explain why you need the money or how you intend to spend it;
- Depending on your plan's terms, you may be able to borrow at a lower rate from your 401(k) plan than you could from a bank or other lender, especially if you have a low credit score;
- Since you're borrowing your own money, you don't have to go through a credit check, and creditors won't come after you if you fail to repay; and
- Part of the interest goes back to you—into your 401(k) account—rather than all of it going to a third-party lender.
On the other hand:
- You'll have to consider what happens if you lose or leave your job—different employers have different guidelines. For example, some may require you to repay your entire outstanding loan balance within a certain timeframe. If this is within a short time of your departure, you may find yourself in a financial crunch. Other employers may allow you to continue making monthly payments as before. Plan guidelines and your choices will vary from employer to employer. Be sure to check what your employer's plan guidelines are before you sign up for a 401(k) debit card.
- Repayments to your 401(k) debit card loans are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account. This is double taxation that would not take place if you took out a conventional loan.
- Those who opt for a 401(k) debit card to meet a short-term cash crunch may find it difficult to pay back the loan and still continue making contributions to their retirement savings. If your contributions stop, so does your company match—and your account grows much more slowly.
- Depending on what market conditions are when you are approved for the 401(k) debit card loan, you could be locking in a loss.
- The fees you pay on the 401(k) loan could be higher than on a conventional loan, depending on the way they are calculated, and especially after transaction and maintenance fees.
- The interest is never deductible, even if you use the money to buy or renovate your home.
- If you go on a leave of absence, your employer may agree to suspend your loan repayments. But you'll have to make up the missed payments when you return—either by increasing the amount of each monthly payment or by paying a lump sum at the end—so that the term of the loan does not exceed five years. This could also put you in a financial crunch.
- While unused funds in your money market account will continue to accrue dividends, the funds that you have borrowed and not yet repaid will not.
Bottom Line: Borrow as a Last Resort
Regardless of how easy it might be to do, borrowing against your retirement savings should be a last, not a first, resort—and done only in emergency situations. If the 401(k) debit card is one of your options, be particularly mindful of the pitfalls that come with the card's use—from a smaller nest egg to a potential loan default that can deal a serious financial blow. Remember that with every swipe comes the potential to wipe out a portion your hard-earned retirement savings.
- FINRA Smart 401(k) Investing
- FINRA Alert: Think Twice Before Cashing Out Your 401(k)
- IRS Publication: 401(k) Resource Guide—Plan Participants—General Distribution Rules
- IRS Publication: Retirement Plan FAQs Regarding Loans