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Tapping a pension or retirement account to get cash for a car purchase can be tempting, especially if you don’t have any other savings available.
While there are no laws that specifically prohibit borrowing from a retirement account to buy a car, there are financial consequences. There may be fees associated with the loan, as well as tax consequences for borrowing from a pension, IRA or 401(k) account.
Taking a loan from a retirement fund can also impact your retirement readiness if it is not managed and repaid responsibly.
How a 401(k) loan works
A 401(k) loan involves borrowing money from your retirement savings and repaying yourself over time. In other words, you’re making a loan to yourself. The loan payments go back into your retirement account.
The IRS requires that 401(k) loans be repaid within five years and that payments be made at least on a quarterly basis. Some plans, however, require more frequent payments and may even allow those payments to be automatically deducted from your paycheck.
Loan repayments will include interest, which is typically a point or two higher than the current prime interest rate, according to Debt.org. Just like the principal payments, the interest will be deposited into your retirement account.
To obtain a 401(k) loan, you will likely be required to complete an application provided by the plan administrator.
Restrictions on 401(k) loans
Not all employer-sponsored 401(k) plans allow program participants to take loans. Check with your plan administrator to find out whether loans are an option that’s available to you.
For retirement savings programs that do allow loans, there are IRS restrictions regarding how much money can be borrowed. The IRS limits 401(k) loans to 50 percent of your vested account balance or $50,000, whichever is less.
However, the IRS rules include an exception to the 50 percent limit — you are always allowed to borrow up to $10,000.
When you request a loan from a 401(k) plan, your employer should provide you with information about the borrowing limit restrictions and any other guidelines. These should include the minimum account balance required to be able to take a loan and the number of loans permitted by the plan.
Drawbacks to using a 401(k) loan to buy a car
Before going ahead with a 401(k) be sure to consider the potential drawbacks carefully as they can be costly and have long-term impacts.
- Fees: There may be fees associated with a 401(k) loan, including origination fees of $50 to $100, which will be taken from the loan proceeds. There may also be maintenance fees of anywhere from $25 to $50. Though these one-time fees may seem minimal, if you’re only borrowing a small amount of money, such as $1,000, you will be losing as much as 15 percent right off the top.
- Leaving the company: If you part ways with your employer before the 401(k) loan has been fully repaid, you may be required to pay the loan’s outstanding balance in full. If you are unable to repay the balance when leaving an employer, the employer can treat the loan as a distribution, which will have tax consequences, according to the IRS.
- Repayment timeline: There is a five-year loan repayment requirement for 401(k) loans. If you do not manage to repay your loan within that time frame, the IRS will view the loan as a distribution and impose not only income tax on the money borrowed but also a 10 percent early withdrawal fee.
- Less potential growth: By dipping into your 401(k), you’ll be shrinking the principal investment, which means you’ll have less money earning interest. This may limit your long-term growth potential.
How to decide if a 401(k) loan is right for you
There may be times when a 401(k) loan is the most cost-effective way to purchase a car, or when borrowing from a retirement fund makes the most sense for your unique financial situation. Ask yourself these questions before taking out a 401(k) loan to purchase a car.
Is the car in your budget?
Consider the type of vehicle that you want. How much will this cost? What is the upfront cost and what will the recurring loan payment and interest be? It’s possible the car that you want simply doesn’t make sense for your budget.
If you need a car, try to find an option that balances that necessity without depleting your investments. Figure out how much car you can afford first and determine if that will meet your needs.
Is this the best rate you can get?
In some cases, because of your credit score or other extenuating circumstances, you may not be able to obtain a competitive interest rate on a traditional car loan. The interest rate available through your 401(k) fund may be more favorable.
Make sure to shop around among banks, credit unions and online lenders to see what rates you can land before committing to a 401(k) loan. If you cannot get a more reasonable interest rate elsewhere, a 401(k) loan may be the right choice.
Is your job stable?
A 401(k) loan makes more sense for individuals who do not plan to leave their current employer anytime soon, and thus would not face the possibility of having to repay the outstanding balance of a 401(k) loan in full.
If you do end up leaving your employer, the loan from your 401(k) or other retirement plan may be treated as a distribution, so think through your future employment plans and goals carefully before taking a loan.
Will it be worth taking the money out?
Whenever money is withdrawn from a retirement fund, you are losing out on the potential growth you could have realized with the money still invested. And that growth could easily amount to more than the interest you’ll be paying yourself as part of the loan repayment process.
Review this trade-off carefully to decide whether the loss of investment will be higher than the interest rate on the loan. Consider talking with a financial professional who can help you crunch the numbers.
The bottom line
When considering your car financing options, remember that your smartest financial decision is the one that will cost you the least.
If you do opt to borrow from a 401(k) or retirement plan, make sure the interest rate you will pay for the loan is the same or lower than the interest rate you might get elsewhere. And be sure you understand all of the tax ramifications of taking a loan from your retirement account.
If you have questions about any of these issues, consider talking with a financial planner who can help you decide whether a 401(k) loan is the best option.