A new lawsuit contends that E*Trade is underpaying interest on cash held in retirement accounts by as much as 500 times less than federal-funds rates.

The class action lawsuit, filed in U.S. District Court for the District of New Jersey on Feb. 1, alleges that the online broker and its parent company, Morgan Stanley Smith Barney, have been paying "paltry" interest rates on cash sweep accounts, even during times when interest rates have been rising.

Among the allegations, the suit states that in 2022 and 2023, as the Federal Reserve increased rates and market rates rose accordingly, E*Trade was paying just a 0.01% yield on accounts of less than $500,000.

"This is approximately 500 times lower than the contemporaneous federal funds rate and is equivalent to $1 of interest on $10,000 in cash per year," the lawsuit states.

Cash held in retirement accounts by most financial institutions is regularly “swept” into interest-paying accounts. The accounts held by E*Trade from Morgan Stanley earned interest rates ranging from one basis point to 45 basis points, depending on how much was in the account, the lawsuit says.

Before Morgan Stanley bought E*Trade in October 2020, interest rates that were paid on cash in retirement accounts dipped to as low as five basis points, the lawsuit states.

The suit notes that Fidelity paid up to 2.7% on similar cash accounts in 2023, while R.W. Baird paid between 2.07% and 4.15%.

"Comparable brokerages such as Fidelity Investments, R.W. Baird, Robinhood, and Vanguard Investments, which did not sweep cash to affiliated banks, but rather swept cash to independent, unaffiliated banks, paid substantially higher rates on swept cash," the lawsuit states.

The lawsuit said E*Trade's rates were eclipsed by the federal funds rate, rates paid by online banks, money market funds and even Morgan Stanley Premium Savings accounts. 

The lawsuit was filed on behalf of Sergey Burmin of Brooklyn, N.Y., and Kenneth W. Luke of Evergreen, Colo., but also includes an undetermined number of others in similar situations, as part of the class action. Burmin holds a Roth IRA account with E*Trade and Luke holds an IRA, according to the lawsuit.

The lawsuit contends E*Trade and Morgan Stanley are making millions in profits on retirement accounts by paying account holders unreasonably low interest rates, the suit said.

The low rate paid to Burmin affected his retirement investing strategy by discouraging him from holding funds in the account in cash and forcing him to reinvest the money sooner than he might otherwise have wanted to, according to the suit.

The situation of allowing banks to set their interest rate on cash held in retirement accounts creates a conflict of interest between the account holder and the bank, according to the lawsuit. The SEC pointed out the same conflict of interest in a staff bulletin issued in August 2022.

Representatives of E*Trade and Morgan Stanley did not respond to a request for comment by press time.