401(k) Debit Card Is NOT a Good Idea

Don’t borrow money from your 401(k) account unless you absolutely have to. If you have to, pay it back as soon as possible.

The Securities and Exchange Commission (SEC) last week issued a warning on using 401(k) debit card to tap into retirement funds to pay for daily living expenses. As the slowed economy put the squeeze on people’s wallets, more and more turn to their retirement savings to pay their mortgages, medical bills, and daily expenses, and a 401(k) debit card just makes the borrowing process a lot easier. While there’s nothing wrong if you have to take a 401(k) loan to put food on the table or keep the roof over your head, withdrawing money from your retirement account with a 401(k) debit card is a bad idea, in general, because of the tax consequences and fees involved in the borrowing. The SEC wants you to know some facts and think twice before swiping your 401(k) debit card at the checkout counter:

You must pay fees and interest on amounts you borrow from your 401(k) plan.

You will likely pay interest and incur fees if you use a 401(k) debit card to borrow money from your retirement savings. While some of the interest you pay will go back into your 401(k) account, a certain amount (called the “margin”) will be paid to the vendor of the card. In addition, the sorts of additional fees that may apply include: (i) an annual fee; (ii) a set up fee; (iii) a cash advance fee; and (iv) fees for other services, such as express delivery.

If you do not pay the money back in the time period required by the plan, there may be significant penalties and tax consequences.

Under IRS rules, you typically must repay the amount you borrow in five years or less, and may not fail to make payments for three consecutive months. If you do not meet those conditions, you must pay taxes on your loan balance. In addition, if you are younger than 59 1/2 years old, you will have to pay a 10% penalty.

The amounts set aside to borrow may earn a lower rate of return than the rest of your 401(k) assets.

The money you decide to borrow is set aside in a money market fund until you withdraw it. Money market funds may earn a lower rate of return than other investment options through a 401(k) account, such as investments in mutual funds or stocks.

Unlike your 401(k) contributions, you must make repayments on your own, and not automatically through a payroll deduction.

Typically, 401(k) contributions are deducted directly from your payroll – once you authorize the deductions, the money goes straight to your 401(k) automatically. Repayments of 401(k) debit card loans, however, are not deducted directly from your payroll – you must pay the balance yourself.

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