Get the Lowdown on the 401(k) Debit Card

March 3, 2008 — -- As the threat of recession looms, some people are searching for extra cash to supplement their incomes.

People used to use their homes as piggy banks, but the mortgage crisis has led many to tap into their 401(k)s and now there's even a new debit card that lets you get money from your retirement savings just as you would a checking account.

"Good Morning America" financial contributor Mellody Hobson tells you the smartest way to handle your money and gives you the pros and cons of the new 401(k) debit card plan.

1. How does the 401(k) debit card work?

There is a financial services firm in New York that is now marketing a debit card called Reserveplus, which allows employees an easy way to tap into their 401(k) retirement savings.

The card is essentially a debit card that allows you access to money from an approved 401(k) loan. Like with any 401(k) loan, an employee applies for the loan with his employer.

If the loan is approved, rather than having the loan amount deposited into your checking account, it is deposited into an account and can be accessed through a debit card.

2. Is this a good way for people to cover their expenses when they are a little short or is this a bad idea?

It is a really bad idea. The notion that you can access your 401(k) savings through a debit card is really troubling. I am a huge fan of debit cards as an alternative to credit cards.

As you know, they are an easy way to avoid the trap of overspending because you can only spend what you have in your account unlike a credit card, which lets you run up a balance in excess of what you can afford.

The problem with a debit 401(k) card is that you are really spending money that you do not have. That money should be under lock and key and used only for your retirement, not for a new flat-screen TV or spring vacation.

In some ways it is even worse than a credit card because the money is expensive to borrow and it prevents your nest egg from growing.

If we look at the math you will see what I mean:

Mellody's Math:

An individual with $20,000 saved in a 401(k) account who contributes $100 every month, assuming an average annual return of 8 percent, would have almost $364,000 saved for retirement in 30 years.

However, the same individual who borrows $10,000 from the plan pays the loan back over five years and stops contributing to the plan while paying back the loan. That same individual would have just $203,000 -- a difference of about $161,000.

An easy rule of thumb to remember: Every $1,000 you withdrawal from your 401(k) plan equals about $10,000 less in retirement income.

3. As troubling as the math sounds, you still say more and more people are taking out a loan on their retirement plans?

The reality is, with a slowing economy and trouble in the housing market, consumers are relying on their retirement savings more than ever to pay their bills.

A survey by the Transamerica Center for Retirement Studies revealed that 18 percent of workers had a loan outstanding from their retirement plan in 2007, which is up from 11 percent the previous year. In fact, there are about $49 billion of outstanding loans on 401(k) assets -- a truly frightening number.

4. Are there any conditions under which you would say it's OK to take money out of your 401(k)?

Generally speaking, money invested in your retirement accounts should not be touched until retirement. The one exception is if you have an emergency and have a financial need related to health or even a death.

In fact, most employer-sponsored 401(k) plans allow for these type of "hardship loans." In most cases, even the hardship loans incur a 10 percent penalty and are taxed at ordinary income.

If you absolutely have to take out a loan from your 401(k), you need to prioritize this loan and pay it off first. Also, if possible, do your very best to try and continue to make contributions toward your plan, especially if your employer offers a company match. Passing up this match is the same as saying "no" to free money for your retirement.

4. What should you do if you're in a pinch and need money?

During times of hardship, your first step should be to assess your spending and find ways to cut back. What expenses in your day-to-day activities can you live without? If you are really in a bind and must get a loan, consider a home equity line of credit. Using your house to pay for major expenses and to cover you in a financial shortfall is a much better vehicle than tapping into money that will undoubtedly be your lifeline in your retirement years.