5 Reasons to Avoid 401(k) Debit Cards

High fees and penalties can gnaw away at your nest egg.

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New 401(k) debit cards make it even easier to flunk do-it-yourself retirement. Investors should be wary of the potential pitfalls of 401(k) debit cards, according to an investor alert from the Financial Industry Regulatory Authority (FINRA), a nongovernmental securities industry regulator.

With a 401(k) debit card, you can generally borrow $50,000 or 50 percent of your vested account balance, whichever is less, the IRS says. Your employer must approve the loan. The amount you borrow is set aside in a separate money market fund and will generally earn income on a tax-deferred basis until you draw it down with the debit card or write a check on the account.

Here are five reasons you should steer clear of 401(k) debit cards.

Lower returns. Returns on relatively safe money market accounts are often lower than dividends to be had elsewhere. For example, between the years 1926 and 2007, the stocks of large U.S. companies earned an annual average return of 10.4 percent, while money market funds or their equivalents earned 3.7 percent, FINRA reports.

Another bill to pay. Instead of paying back your loan with a payroll deduction as you would with a traditional 401(k) loan, you receive a bill each month, including interest and fees. And only some of the interest goes back into your 401(k) account. The rest goes to the debit card vendor. Interest starts accruing as soon as the transaction clears, not after a grace period as with credit cards.

Penalties are high. You typically have to pay the full amount back in five years or less, unless your plan allows for longer repayment periods to purchase a primary residence. If you fail to make payments for three consecutive months or default, the debit is considered a 401(k) distribution. That means you will have to pay income taxes on it if you're not 59½ or older, plus a 10 percent penalty for early withdrawal.

Too many fees and charges. Interest rates generally follow the prime rate, like credit cards, so they can fluctuate. The debit card vendor collects a margin based on how much you borrow. Also watch out for setup fees, annual fees, return-payment fees, and cash-advance fees (currently $2) each time you use the debit card to obtain cash at an ATM or through a bank teller.

Cracking your nest egg. "Regardless of how easy it might be to do, borrowing against your retirement savings should be a last resort and done only in emergency situations," says John Gannon, FINRA senior vice president for investor education. "Be mindful of the hazards that can come with using the card, from a smaller nest egg when you retire to a possible loan default that can deal a serious financial blow.... With every swipe comes the real potential to wipe out a portion of your hard-earned retirement savings."

You can check out other pros and cons of 401(k) debit cards here.