Debit cards linked to 401(k) accounts give individuals the ability to access funds approved for loans from their retirement savings quickly and easily. But given Americans' already low rate of saving for retirement, is it such a good idea? If you have a 401(k) plan and are considering applying for a loan from your account, it is crucial to understand how a 401(k) debit card works if your employer allows you to access the loan in this way. Let's take a look at the potential pros and cons of using a debit card to access your 401(k) loan funds, and how to determine whether you should to use the feature. (For background reading on 401(k) plans read The 4-1-1 on 401(k)s.)
How They Work
Traditional debit cards allow you to withdraw money or make charges against a personal bank account. Like a bank account-linked debit card, the 401(k) debit card allows you to withdraw money from your own 401(k) account; essentially, you are withdrawing your own money from a money market account, which is funded with a loan from your 401(k) account. However, the similarities end there. The 401(k) debit card has more in common with a credit card and is sometimes called a 401(k) credit card because of the fees and penalties that usually apply, as well as the repayment features. (For related reading, see Credit, Debit And Charge: Sizing Up The Cards In Your Wallet.)
To use a 401(k) debit card, you must first apply for a loan from your 401(k) account and agree to repay the amount you borrow. You must also get approval for the loan from your employer. Your employer may provide approval for a revolving or non-revolving line of credit. A revolving loan means that the money you repay on the loan may be borrowed again, similar to a credit card. With a non-revolving or fixed loan, you can't automatically borrow money you repay; instead, you must apply for a new loan, which is subject to a new review and approval process with your employer. The amount you can borrow depends on how much money you have already deposited into your 401(k) account and your vested balance. Under IRS rules, the most you can borrow is the lesser of $50,000 or 50% of your vested account balance. An exception may be made to allow you to borrow up to $10,000, even if this exceeds the 50% limit.Your employer has the discretion to limit your loan (for a variety of reasons) and the purpose for which the loan can be used. (For more on 401(k) loans, see Qualified Plan Loans: Guidelines To Operations.)
Once your employer approves your loan application, the loan amount that you requested is transferred into a money market fund and a debit card that you can use to withdraw the funds is sent to you. Some plans enable you to also write checks against your loan amount. The total amount that you borrow against your loan - whether by using your 401(k) debit card or writing a check - is tallied up daily and considered a single "loan" for the day. Amounts used on different days are considered separate loans and are subject to their own terms of repayment.
You will receive a bill each month (similar to a credit card bill) that lists your loan amount, how much you have withdrawn on a daily basis, and how much you need to repay. Because this is a loan, you will be billed for both the principal amount you have borrowed and the interest accrued. The interest charged on your debit card use is tied to the prime rate; you will also be charged a variable fee (called the "margin"), which is paid to the debit card vendor. The margin is based on the amount you withdraw each month and you will continue to owe interest until the amount is repaid in full. Just like a credit card, you will have a due date by which payments must be made and minimum payment amount is due.
There can be benefits to using a debit card if you are managing your 401(k) loan well. Let's look at several potential benefits to using a 401(k) debit card:
- Shortens time to access funds. Once you're approved for your 401(k) loan and receive your debit card, you can begin accessing funds immediately.
Longer repayment period. Using a debit card may give you more time to repay the loan if you leave your job. With a traditional 401(k) loan, many employers require that you repay the loan in full when your term of employment ends. Check with your employer and carefully read loan documents so that you know your repayment options and responsibilities.
- Variable repayment amounts. Instead of being required to repay a fixed amount each month, 401(k) debit cards require that you only repay the minimum amount based on your outstanding balance.
Continue earning interest. Because your loan funds are deposited into a money market account instead of sent to you, they will continue to earn the same amount of interest at the money market rate.
- No reason necessary. Because you can withdraw funds at your own discretion, you don't need to state a reason for drawing down your loan balance. (For more insight, see Sometimes It Pays To Borrow From Your 401(k).)
For all the potential benefits of 401(k) debit cards, there are as many potential negatives. For example:
- More expensive. You could be charged a higher interest rate than with a traditional 401(k) loan and you may be charged additional fees, such as a set-up fee and cash advance fee for each time you swipe your card to withdraw funds.
- No payroll deductions. With traditional 401(k) loans, many employers allow workers to have their loan repayment amount automatically deducted from their paychecks - not so with 401(k) debit card loans. You have to remember to make the loan payment on your own, as you would with any other type of bill. If you miss making payments on your loan for three consecutive months, your loan could default, resulting in the amount being taxable; if you are younger than 59.5 when you default, you may have to pay the IRS a 10% early distribution penalty.
- No grace period and losing out on interest. You will be charged interest on the money you withdraw immediately (no grace period as with credit cards) and a portion of the interest (the margin) goes to the debit card vendor.
- No interest deduction. Unlike with a home equity loan, you cannot deduct the interest you pay on a 401(k) loan from your taxes, even if you are using the money for house-related reasons (i.e. to repair, renovate or add on to a home).
- Accidentally overdrawing your loan account. You may accidentally overdraw your account and face steep penalties. (For more insight, see Eight Reasons To Never Borrow From Your 401(k).)
Before Applying for a 401(k) Loan and Using a 401(k) Debit Card
Before submitting an application to borrow money from your retirement savings plan, try to answer some important questions related to your current financial abilities and your future financial goals such as:
- Why are you withdrawing this money? Are you taking the loan out to meet an important financial goal – i.e. college tuition, buying a home - or do you need the funds to pay off other debt or to purchase non-necessities? Carefully evaluate why you're borrowing the money before you apply.
- What other options do you have besides borrowing against retirement savings? Are there other, less expensive options?
- What income or assets do you have to repay the loan?
- How much is this loan going to cost? In addition to the principal you're borrowing, add fees and interest to get a clear picture of the total loan cost.
- When will you (or can you) start contributing to your 401(k) again?
It's important to consider how much money you may be missing in employer-matched funds if you stop contributing to your 401(k) account while you're repaying the loan. Also be aware that taking money out of your retirement savings means you will lose out on the compound interest those additional funds would have accumulated.
If you have been approved for a 401(k) loan and plan to use a debit card to access funds, be sure to read the loan agreement documents and understand the terms and fees associated with your loan.
Withdrawing money from your 401(k) should not be done hastily. Evaluate all your options to know the best, most affordable loan option and, if you choose a 401(k) loan, create a plan to repay the loan as quickly as possible so that your retirement savings can continue to grow on a tax-deferred basis. If you use a 401(k) debit card responsibly and make your payments on time according to the terms of your loan, it can be a convenient way to access your loan funds.
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