If you plan to buy a car, but do not have the savings available for a down payment, you may wonder if you can take out a loan from your 401(k) plan to cover the initial costs of your purchase. Federal law does not place restrictions on the specific reasons you can borrow from your 401(k) account; however, you should consider this financial strategy carefully before committing to a 401(k) loan.
Your 401 (k) Plan Restrictions
Although federal law does not prohibit taking out a loan from your 401(k) plan to purchase a vehicle, you may be subject to restrictions imposed by your company's plan administrator. The plan administrator may only permit loans for specific reasons, or may only allow a loan if it qualifies as an immediate hardship. In most cases, purchasing a vehicle will not qualify as a hardship, so it is wise to check with your 401 (k) administrator prior to taking out any funds.
Remember Interest Payments
If your plan administrator permits taking out a 401(k) loan to purchase a vehicle, you will pay interest on the money you borrow. The Internal Revenue Service requires 401(k) plans to charge interest competitive with other lenders – the interest is typically equal to the current prime interest rate plus 1 percent or 2 percent. The interest you pay on a 401(k) loan is not tax-deductible. However, most plans add interest payments to your 401(k) account balance when you repay your loan.
Suspension of Contributions
Depending on your plan's rules, your administrator may require that you reduce or suspend contributions to your 401(k) plan until you repay your loan in full. This reduces your ability to build your retirement savings while your loan is outstanding. Over time, this can significantly impact your available account balance at retirement.
401(k) Loan Fees
Your 401(k) plan may charge a loan origination fee when you take out a loan – the fee varies according to the plan's rules, but plans that levy fees often charge 1 percent of the loan amount. Your plan may also charge an annual service fee for each year that a portion of your loan remains outstanding. However, checking with your plan's administrator will clarify these fees before you commit to the loan.
401(k) Loan Limitations
You cannot borrow the full balance of your 401(k) account to pay for a vehicle. Federal law limits 401(k) loans to $50,000 or half of your account balance, whichever is less. There is an exception to this rule, however. If 50 percent of what is in your 401 (k) amounts to less than $10,000, then you can borrow up to the full $10,000. It is worth noting, plans are not required to include this exception.
Alternatives to a 401(k) Loan
For those who qualify, another type of loan will likely be more viable while also keeping your retirement savings intact. If you opt for a low-interest-rate loan from a local credit union, for example, you'll likely find your interest rate is much lower. The national average for a car loan as of 2018 was 4.21 percent, according to ValuePenguin.
- ValuePenguin: Average Auto Loan Interest Rates: 2018 Facts & Figures
- Money-Zine: 401(k) Loans
- What is a 401(k) Loan and How Does it Work?
- IRS: Retirement Topics - Plan Loans
- IRS. "Retirement Topics - Plan Loans." Accessed Nov. 2, 2020.
- FINRA. "401(k) Loans, Hardship Withdrawals and Other Important Considerations." Accessed Nov. 2, 2020.
- IRS. "Relief for Taxpayers Affected by COVID-19 Who Take Distributions or Loans From Retirement Plans." Accessed Nov. 2, 2020.
- Charles Schwab. "The Charles Schwab Guide to Finances After Fifty: Does It Make Sense to Borrow From My 401(k) if I Need Cash?" Accessed Nov. 2, 2020.
- Maxwell Locke & Ritter. "Options for Your 401(K) Plan at a Former Employer." Accessed Nov. 2, 2020.
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- The Pension Research Council at the Wharton School. "Financial Literacy: Implications for Retirement Security and the Financial Marketplace: Chapter 4: Financial Literacy and 401(k) Loans," Page 71. Accessed Nov. 2, 2020.
- IRS. "Retirement Topics - Bankruptcy of Employer." Accessed Nov. 2, 2020.
Owen Pearson is a freelance writer who began writing professionally in 2001, focusing on nutritional and health topics. After selling abstract art online for five years, Pearson published a nonfiction book detailing the process of building a successful online art business. Pearson obtained a bachelor's degree in art from the University of Rio Grande in 1997.