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.M

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.

Some of the added interest charges could be offset. Unlike with standard, lump sum-based 401(k) loans, ReservePlus interest charges only apply to withdrawn funds while the rest of the earmarked loan funds continue to gain interest.

The cost of borrowing made easy

Weller outlined how debit card withdrawals on 401(k) funds could cost significantly more than simply taking out a standard, lump sum-based 401(k) loan.

Weller estimates that payments for five years on $5,000, under the ReservePlus terms, will cost borrowers about $425 more than would a standard 401(k) loan of $5,000. But what worries Weller more than the added fee and interest costs is making it too easy for cash-strapped consumers to access 401(k) savings to pay for everyday items.

According to Weller, most 401(k) plan administrators place restrictions on 401(k) loans, such as restricting their use to medical emergencies. There are also provisions allowing early withdrawal of 401(k) funds without penalties in cases of extreme personal hardship. The ReservePlus loan program allows access to 401(k) funds for anything that can be purchased with a Visa debit card or for cash at an ATM.

 “We are not crazy about 401(k) loans, but there are situations where they are unavoidable,” Weller says. “The reason why people don’t borrow frivolously on them (401(k) plans) now is because there are restrictions on them.”

Even standard 401(k) loans diminish long-term retirement accounts by an average 13 percent, Weller says. Easier access to 401(k) funds likely would diminish those savings even more, he says.

Weller also worries that 401(k) loan default rates would rise with debit card-based 401(k) loans because consumers make monthly payments on their own to a third party instead of tying 401(k) loan payments to paycheck withholding.

A loan default means that borrowers would be hit with the full tax payments and penalties applied to an early withdrawal before the age of 59½.

Gail Hillebrand, a senior attorney for Consumers Union, says using 401(k) savings as a line of credit with an easy-access debit card attached opens the door for consumers to borrow smaller amounts more frequently from 401(k) savings. The added fees and higher interest could pile up.

“If you are borrowing small amounts, these set up fees will make it quite expensive to borrow and if you borrow large amounts, you may be decimating your retirement,” Hillebrand says.

Allowing borrowers to tap 401(k) savings for a line of credit with a debit card also sends the wrong message to consumers about saving for retirement, Hillebrand says.

“A 401(k) loan ought to be a carefully considered, last-resort choice and putting that on a debit card is going to make it too easy to borrow against your future,” she says.

Regulators also are taking a dim view of 401(k) loans with debit cards attached to them. John Gannon, senior vice president of the Office of Investor Education Financial Industry Regulatory Authority, or FINRA, testified that such loans carry new risks for borrowers, including possible tax penalties for missed payments and the potential for third-party creditors to take 401(k) funds in a personal bankruptcy. Savings in 401(k) plans generally are protected from creditors under federal bankruptcy laws.

Filling a 401(k) gap?

Access to card-based 401(k) loans is limited so far. Reserve Solutions is the only company offering these loans, according to David Wray, president of the Profit Sharing/401(k) Council of America — a Chicago-based nonprofit group that closely tracks 401(k) plans offered by employers. Wray says it is his understanding that only two employers are offering the ReservePlus product to employees.

Reserve Solutions declined an interview. But Bruce R. Bent, chairman of Reserve Solutions, told the Special Committee on Aging that the ReservePlus debit card-based 401(k) loans give consumers more control and flexibility than traditional 401(k) loan options while still maintaining the benefits of a 401(k) savings plan.

“With ReservePlus, the participant’s funds remain in the plan, continuing to earn sheltered investment returns until the participant withdraws them,” Bent said in his testimony. Plan administrators still must approve any loans under IRS rules with the ReservePlus product, he said.

Bent testified that debit card-based 401(k) loan amounts are on average about 30 percent less than standard 401(k) loan amounts. The average 401(k) loan amount in 2007 was $8,100, according to Hewitt Associates, a Chicago-based human resources consulting firm.