Net Gains: Why Raiding Your 401(k) Is a Bad Idea

June 3, 2008 — -- I considered it a bad idea from the beginning. Now, securities regulators agree.

I'm talking about the 401(k) debit card, which could wipe out the retirement security of countless Americans by allowing them to borrow from their retirement savings for the most trivial of expenditures.

Worried about such a scenario, the Financial Industry Regulatory Authority (FINRA) last week warned investors about the dangers of tapping your retirement savings for a night out on the town or the purchase of a new tech gadget.

"Remember that with every swipe comes the real potential to wipe out a portion of your hard-earned retirement savings," FINRA senior vice president for investor education John Gannon said.

FINRA, an industry self-regulatory organization, said the 401(k) debit card actually is a "debit and credit card rolled into one."

It acts like a debit card by allowing you to spend your own money, but unlike a normal debit card linked to a bank account, it rings up interest charges and other fees. Each transaction is a loan that must be paid back to the 401(k) account. Default on the loan and you will be hit by taxes and penalties by the IRS.

Even if paid back on time, a 401(k) loan robs the recipient of investment earnings that otherwise could compound their way to a prosperous retirement.

Earlier this year, I calculated that $3,500 borrowed from 401(k) accounts by my wife and I may have cost us about $18,000 in future retirement savings. I called it "one of the dumbest financial moves we ever made" in a February column.

Thankfully, at the time, I couldn't magnify my error by signing up for a debit card to tap my retirement savings some more.

Introduced last year by a company called Reserve Solutions, the 401(k) debit card caught public attention earlier this year and came in for harsh criticism from financial planners and other retirement-savings advocates.

The New York company pitches the 401(k) debit card as a cost-saver for employers and a boon to retirement-plan participation by eliminating "burdensome restrictions associated with taking loans" from worker accounts.

"With the Reserve Solution loan program, we're encouraging investing, not borrowing," the company's Web site states.

But FINRA took a look at the details of the plan and came to a different conclusion.

According to FINRA, when a retirement plan participant signs up for a 401(k) debit card, an approved amount is set aside in a separate money market fund from which the borrower draws using the debit card.

While the funds remain in the money market account, they earn dividends, but they are unlikely to be the kind of returns one needs to earn on long-term, retirement savings.

As FINRA noted, money market funds earned an average annual rate of return of just 3.7 percent between 1926 and 2007. That compares to the 10.4 percent earned by U.S. large cap stocks over the same period.

With the 401(k) debit card, the amount borrowed each day is totaled and counted as a single loan. Use the card on a second day and any transactions on that day will count as a separate loan. This means you could have multiple loans, each with different repayment terms.

The interest on the 401(k) loan starts accruing as soon as a transaction posts to an account. There is no grace period as there can be with a credit card.

In addition to the interest charge, there are fees tied to a 401(k) debit card that go into the pocket of the card provider. These include a "margin" based on the amount borrowed from your 401(k), setup and annual fees, and a $2 cash advance fee every time the card is used to obtain cash at an ATM.

A major disadvantage of the 401(k) debit card compared to a traditional 401(k) loan is the repayment method. Typically, a 401(k) loan is repaid through payroll deduction, making it more likely the loan will be repaid on time.

The 401(k) debit card, however, increases the chances of default by requiring the borrower to make the payments directly.

Generally, 401(k) loans must be paid back within five years. For a home purchase, the repayment period may be longer. In either case, if you don't repay the loan in time, or miss payments for three straight months, then the loan is considered in default. That would mean you owe taxes on the amount outstanding plus a 10 percent penalty if you're under age 59½.

As with any 401(k) loan, the debit card version means your retirement savings take a hit in several ways:

Lower investment earnings as the money removed from retirement savings lowers the account's compounding potential.

Repayment using after-tax dollars compared to the pre-tax dollars borrowed. That means $1 borrowed could require $1.25 to pay back what is owed.

Lowering future contributions as the borrower is forced find the money needed to make the loan payments.

"Regardless of how easy it might be to do," FINRA warned, "borrowing against your retirement savings should be a last, not a first, resort -- and done only in emergency situations."

Let's hope this is one warning investors take seriously.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com