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.
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.
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. 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.
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 is typically about 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.
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.
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, though, you'll likely find your interest rate is much lower. The national average for a car loan is currently 4.21 percent, according to ValuePenguin.