Wherever middle-class Americans turn these days, they face higher bills and less income. Amid a sharply slowing economy, many find solace in their ability to borrow from themselves through their 401(k) retirement savings plans to help them smooth over an economic rough patch. Borrowing from one’s retirement account should be a last resort for people desperate to pay for medical care, or their mortgage, or other necessary expenses, but borrowing from a 401(k) plan as if it were an ATM machine makes little economic or financial sense.
Yet that’s exactly what a relatively new product, the 401(k) debit card, allows retirement savings plan participants to do—complete with a bevy of costly new fees. 401(k) debit cards are supplied through an employer’s agreement with a company such as ReservePlus, the largest current provider of the card. With a 401(k) debit card, individuals are allowed to take out loans on their retirement savings up to an amount approved by their employer, and place this money into a separate ReservePlus account that can be accessed like a normal checking account.
The stated goal of the card is to create convenience and flexibility for users, and to facilitate access to one’s 401(k) before retirement. What is not always readily apparent is that any money taken out must be paid back in full plus additional interest and fees to the company offering the 401(k) debit card.
Providing easier access to retirement savings accounts before retirement—with exotic additional fees to boot—is exactly the wrong direction to go. While access to one’s 401(k) may be necessary to pay for an emergency, substantial hurdles need to be in place to protect the maximum saving amount for its intended purpose—retirement. It is important to recognize that, while possibly necessary, a loan from a 401(k) plan can do serious damage to one’s retirement security.
In a new report from the Center for American Progress, Christian Weller and Jeff Wenger calculate that a $5,000 loan for a typical middle-income worker can reduce retirement saving by between 13 percent and 20 percent over a 35-year career. Making it easier for people to borrow can be harmful to a family’s retirement income security.
This is even more harmful when a 401(k) loan is loaded up with additional fees that distract retirement saving. Opening up an account costs $75, with an annual maintenance fee of between $25 and $50, with an additional $2.00 fee for any cash withdrawals from the account. But that’s not the biggie. As with other 401(k) loans, the loan is tied to the prime interest rate, as well as a 2.90 percent to 3.25 percent service fee charge that accrues to the debit card provider. This added service fee means that the provider receives approximately $425.00 for each five-year $5,000 loan—if it is repaid over the maximum allowable five years.
Loans through a 401(k) debit card costs about $425 more in the long run than a conventional loan, and this additional cost goes into the pocket of the cards’ provider. To cover this added cost, the borrower essentially needs to increase the original loan amount by 8.5 percent. Or looked at another way, the loan repayment takes longer because of the added interest rate charge. If a borrower made the same loan payments to pay off the 401(k) debit card with an interest rate of 8.5 percent over five years it would take 60 months, compared to paying off a conventional loan with an interest rate of only 5.5 percent, which would take the borrower only 49 months. The added interest rate charge requires an additional year of loan payments.
Because of these extensive costs and risks associated with 401(k) debit cards, Sens. Charles Schumer (D-NY) and Herb Kohl (D-WI), have introduced legislation that will ban 401(k) debit cards and other products that “raid” retirement savings accounts. The proposed bill, S. 3278, was introduced last week and sent to the Senate Finance Committee for review. The legislation calls for employer benefit plans to be prohibited from making loans through credit cards or other third parties. The goal of the bill is to stop companies from taking advantage of citizen’s 401(k) savings in order to make a profit, as well as to insure that Americans’ retirement funds are protected and contain enough money for a comfortable retirement.
Sens. Schumer and Kohl are on the right track with this legislation. Companies preying upon the 401(k) savings of Americans present a serious problem. This legislation will protect Americans from companies looking to profit from financial desperation, as well help ensure quality retirements for Americans. The fact that Americans are tapping into their 401(k) savings early is already a growing problem. Legislation to outlaw 401(k) debit cards can limit the damage that is being done.
Christian E. Weller is a Senior Fellow at the Center for American Progress. For more information on his retirement savings research and analysis, please go to the Retirement page of the Center’s website. For more information on 401(k) debit cards, please see the following references: