August 30, 2008

By David Gosnell

The Cost Of Debit Cards Linked To 401(k)s

What if consumers could dig into their 401 (k) savings with a debit card and without those pesky taxes and penalties? One company offers this new use of a debit card as a convenient line of credit tapping into retirement savings. But before you start buying groceries with your 401 (k) savings, consider the cost.

It’s an unimaginably big number – $3 trillion – that’s the total estimated worth of assets in 401(k) savings plans at the end of 2007. Compare those assets with shrinking available credit on credit cards and disappearing equity lines of credit – the result of the mortgage meltdown. It’s tempting, then, to eye all those assets sitting in a 401(k) savings plan as a new type of credit for cash-strapped consumers to tap. New York City-based Reserve Solutions Inc. is offering these so-called 401(k) debit cards, which are actually loans tied to retirement savings plans.

On the surface, these loans have much in common with standard loans from 401(k) savings. They carry no tax penalties and are not considered early withdrawals. But that is where the similarities end.

The Reserve Solutions, debit card-based 401(k) product, called ReservePlus, comes with higher interest rates and fees never seen with standard 401(k) loans.  For example, Reserve Solutions charges $75 to set up a 401(k) debit card account and a $2 fee for withdrawals. The company also charges interest of up to 3.25 percent more than a standard 401 (k) loan, which typically carries an interest rate of one percent plus the prime rate. Unlike a standard loan from 401(k) savings, ReservePlus keeps its added interest charges. Interest charges are plowed back into savings when a typical 401(k) loan is paid back.

Borrowers using the ReservePlus card-based loans essentially set up a line of credit by reserving an amount inside a 401(k) plan and then allows borrowers to make loans to themselves via a debit card withdrawal. The unused portion sits in a money market account, so those funds continue to gain interest without early withdrawal taxes and penalties. Interest charges and fees only apply to the amount withdrawn. Traditional 401(k) loans are taken out in a lump sum.

Christian Weller, a professor of public policy at the University of Massachusetts and senior fellow with the nonprofit Center for American Progress, recently testified before the U.S. Senate’s Special Committee on Aging on behalf of a measure that would ban debit card-based 401k loan options.

Weller worries giving savers a debit card makes it too easy for consumers to tap into tax-deferred retirement savings for everyday expenses. Traditional 401(k) loans usually come with restrictions, such as using it for a down payment on a home. “The way ReservePlus sells 401(k) debit cards is that it makes it easier to access your money. In the past, employers have often put restrictions on when you can borrow from your 401(k),” says Weller.

The take-it-as-you-need-it approach using debit card withdrawals may have an appeal to some savers, Weller admits. But cash-strapped savers likely will get used to using their 401(k) debit cards to pay bills and the withdrawals that come with higher interest and fees will accumulate, Weller predicts. “They will use all that money to pay all their bills off, their health care or their mortgage or other things,” he says. “We want people to be in a situation to really carefully think about the money and taking out money from their 401(k)s.”

Weller estimates that users of ReservePlus will pay at least $400 more on a $5,000 loan paid back in five years than those who take out a traditional 401(k) loan paid back in five years.

Reserve Solutions chairman Bruce Bent, in testimony before the Senate Committee, assured the congressmen that its debit card-based 401(k) loan product still abides by all employer restrictions on 401(k)s loans and ReservePlus does not change loan terms and repayment terms set up by plan administrators.

Bent also testified that these card-based 401(k) loans, while carrying higher interest and fees than traditional 401k loans, reduces retirement loan amounts and encourages workers to participate in tax-deferred retirement plans. “A traditional loan actually forces money out of a plan by requiring a participant to withdraw the entire amount immediately in a lump sum,” Bent said. “When participants know they have access to the money, they contribute more into the plan and take less out of the plan.”

Reserve Solutions has been offering these card-based loans since December 2007 and has not divulged information on how many borrowers are using it nor how many employers offer it. It is the only company known to be offering loans on 401(k) savings with debit cards.