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Stacked Deck: Debit Card That Taps 401(k) Retirement Savings Is Easy to Use — and Abuse

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RISMEDIA, July 23, 2008-(MarketWatch)-Debit cards are straightforward. You use them for purchases and money is deducted from your bank account. But when the debited account is your 401(k) retirement plan, critics angrily line up to take a swipe at that piece of plastic.It’s not hard to see why. The 401(k) debit card lets you borrow from retirement savings and pay yourself back with interest over time, much as you would with a typical 401(k) loan. Only the card makes it much easier to crack your retirement nest egg; all you do is shop, swipe and sign.

To the advisers, brokers and financial institutions pushing workers to save more for their futures and consider the 401(k) sacred, this debit card is not just objectionable, it’s blasphemous.

“We absolutely hate it,” says Jean Setzfand, director of financial security at AARP, the organization for people 50 and older. “A 401(k) loan is a last resort.”

“A horrible idea,” adds Linda Lubitz Boone, president of investment advisory firm Lubitz Financial Group in Miami. “It’s hard enough to save to begin with.”

“Terrible,” fumes Robert Wuelfing, president of the Spark Institute, a trade group for the retirement-services industry. “If you’re taking out a 401(k) loan, it should be a thoughtful process, not to buy a big screen TV.”

Even official watchdogs are on alert. The Financial Industry Regulatory Authority, or FINRA, recently issued a stern warning about 401(k) debit cards, calling them “a tempting convenience that can have significant repercussions” on your retirement security.

The cards also have become Public Enemy No. 1 for some Washington lawmakers; Sens. Charles Schumer, D-N.Y., and Herb Kohl, D-Wis., blasted them last week as an apparent abuse of 401(k) plans and proposed legislation to outlaw them.

Debit details

The rub is that employees evidently like the ability to borrow; studies show it actually makes them more likely to contribute to a retirement plan. Most 401(k) participants have access to loans and about 20% have gone through hoops and hassles to get one.
Yet employers seem to be drawing the line with the debit card. Though the product has been around for several years, few companies offer it — and probably won’t. They’re focused more on automatically enrolling U.S. workers in plans, not handing out quick and easy loans.

Reserve Solutions, a unit of New York-based money manager The Reserve, claims on its Web site that its ReservePlus debit card “encourages ‘smart borrowing’ practices.” Bruce Bent, The Reserve’s chairman, says the 401(k) industry and lawmakers have a “gross misunderstanding” of the product and that access to retirement funds can spur employees — especially lower-income and younger workers — to save for retirement.

“We have to do a better job on education so people can appreciate what [the card] does, instead of having this visceral reaction that it’s bad,” Bent says.

The heightened controversy about 401(k) debit cards comes with the times. There’s a growing concern that with things so tough, people living paycheck to paycheck will increasingly turn to retirement savings as a source of cash. Mortgaging your future — unless it’s for an emergency or to enhance your education or career — is almost always a poor decision. You’ll have less money to support yourself after you retire or you’ll have to work more years before calling it quits.

Pros and cons

The debit card aggravates that problem, but it has advantages and disadvantages versus standard 401(k) loans.

For starters, the ReservePlus card is flexible; it can be used multiple times, for any purpose. As with a traditional loan, employers set a borrowing limit based on how much you’ve saved for retirement. By law, the upper limit is generally $50,000 or 50% of your account balance, whichever is less. The approved amount is set aside in a money-market fund and earns tax-deferred interest until you use the card.

With every transaction, you have five years to pay back the money, and the interest rate — now about 8% — may be better than you can get elsewhere, especially if you have sketchy credit. Also, you’re paying yourself instead of a credit-card company, and on more favorable terms.

One major advantage of a debit card is that if you’re laid off or leave the company, there may be no pressure to reconcile the debt immediately. With a traditional 401(k) loan, the outstanding amount must be repaid in full, usually within 90 days. Otherwise the loan amount is considered a taxable distribution.

That means you’ll pay income tax and — with few exceptions — a 10% early withdrawal penalty if you’re younger than 59 1/2. With a debit card, your plan may allow you to write a check to cover each monthly statement until the loan is settled.

Be careful; sometimes the easiest money to get is the hardest to pay back. Fail to make timely payments for three consecutive months or default and you’ll be hit with those same distribution taxes and penalties.

And since the 401(k) reimbursement isn’t coming out of your regular paycheck, as it would with a traditional loan, it’s just like any other bill, so you’ll need to be diligent and organized.

Moreover, the debit card can be expensive. In addition to the finance charges, expect set-up, maintenance and cash-advance fees. Repayments are made with after-tax dollars that will be taxed again when you start drawing on your account, and the interest isn’t tax-deductible.

Look closely at that interest rate too. It’s based on the prime rate of 5% — money that returns to your 401(k) account when you repay it. But the other 3% or so goes directly to Reserve Solutions.

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