401(k) debit cards make loans a risky business
By David Gosnell • Bankrate.com

With banks getting stingier about credit cards and home equity lines of credit, where should a consumer turn?

Some might be tempted to crack open their 401(k) retirement nest eggs to find themselves some extra cash. Mix in easy access to that credit via a debit card and borrowers might think they're looking at credit nirvana.

The money is there: 401(k) plan assets exceeded some $3 trillion by the end of 2007, according to the Investment Company Institute, an association of U.S. investment companies.

But 401(k)-funded debit cards could be costly, particularly compared to standard 401(k) loan programs. The card-based loans carry higher interest charges and fees not seen with typical 401(k) loans.

Using savings in a tax-deferred 401(k) plan as a line of credit through debit cards currently is not a common option. Only one firm -- Reserve Solutions Inc., based in New York City -- is testing the waters on these card-based retirement savings loans.

Still, critics of these card-based 401(k) loans already are sounding alarms over the potential damage consumers could do to their retirement savings if these unique 401(k) loans gain in popularity.

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 401(k) loan options.

"I think this is the wrong way to go," Weller says of using 401(k) savings available through a debit card as a line of credit.

Beware of higher interest, new fees
The debit card-based 401(k) loans are significantly different from typical 401(k) loans. With the typical 401(k) loan, borrowers simply lend themselves a lump sum from their 401(k) savings and pay the loan back to a plan administrator through payroll withholdings.

A debit card-based 401(k) loan is managed by a third party instead of a plan administrator and the terms are more complex.

The Reserve Solutions product, called ReservePlus, is based on the existing loan options offered through many 401(k) plans today. But there are added fees and interest charges.

Under Internal Revenue Service rules for tax-deferred savings plans, 401(k) plan borrowers can loan themselves up to $50,000, or half the value of a retirement account, whichever is less. The loans carry interest charges, typically 1 percent over the prime rate, and must be paid back within five years. Investment gains on these funds do not accrue as the loan is being paid off. The loan amount still is protected from early withdrawal taxes and penalties, and borrowers pay these loans back through payroll withholdings.

For its program, Reserve Solutions, with approval by a participating employer, reserves an amount specified by a 401(k) saver and places those funds in an interest-bearing money market account within a 401(k) plan.

As with standard 401(k) loans, there are no tax penalties because the ReservePlus loans are not considered early withdrawals. This account essentially becomes a line of credit through ReservePlus. The borrower is issued a Visa-branded debit card to withdraw money from this account for use wherever Visa is accepted. When a withdrawal is made either at an ATM or via a purchase, a loan is established under IRS rules for 401(k) loans.

It is at this withdrawal point that extra fees and interest are applied.

ReservePlus charges include:

• $75 to open a line of credit account. • $25 to $50 for an annual maintenance fee. • $2 fee for each withdrawal. • $10 for a card delivery fee. • Up to a 3.25 percent variable rate interest charge on top of typical 401(k) plan loan interest charges, commonly the prime rate plus 1 percent.

Under terms for standard 401(k) loans, interest charges are plowed back into a 401(k) fund when the loan is paid off. Reserve Solution's added interest is kept by the firm.

Also, variable rate charges mean that the borrower can't be certain what the loan will cost. Payments by borrowers are made monthly to ReservePlus, not directly to a plan's administrator. Borrowers must establish an automatic withdrawal from a bank account for the payments.