Considering Taking a Loan From Our 401K - Is There a Disadvantage?

[BethR]

We are hoping to buy a new car sometime in the next week (or month ) and we are considering taking loan from our 401K to pay for it. (Sorry guys, we do not have the cash. Please don't yell. )

Please help me to figure this out. If we take the loan from our 401K, we will be paying 9.25% interest, which goes to back to us (I THINK).

Is there any good reason (other than maybe a lower interest rate which does NOT go to us) to finance another way?

 

[musicmama]

Check with your plan very very carefully. With the plan at my last company, once you take a loan you can't contribute for some period of time. Also, the interest goes to the plan company (or at least it did with the plan I had).

I would definitely investigate any lower financing options - maybe through the dealer or through a credit union.

 

[sk!mom]

I would not touch my retirement funds for anything other than a true financial disaster (think life and death here). If I needed a car and did not have the money set aside, then I would look for the best deal on a gently used car. I would then finance it at the lowest rate I could get and pay it off as soon as possible.

I have never looked in depth at borrowing from a 401K so I don't know all of the details. I just don't have a good feeling about raiding my retirement. I would add that the only people that I know who have done it have then done it more than once. It has become a bailout sort of like those who consolidate or refinance more than once.

 

[CindyKansas]

I think different companies have different rules to follow. I know I took a loan out on my 401K 3 years ago and the interest rate was 4.5%, paid to me and I still contributed to my plan every pay period. With my plan, you can actually go online and apply for a loan.

 

[mom2grace]

We took a loan to save our mortgage. I don't believe it was "Free" like I think you are assuming.

In our plan, it's DH's employer so I don't know the specifics, but I do know that we have to pay it all back before we could take out more, and if we leave the company (or get fired) we have to pay it all back immediately.

I would suggest that you just do a regular car loan.

 

[dec181981]

i did this a couple of years ago when i needed a down payment on a car. I paid 5.5% intrest and it did get paid to me. I was still able to contribute to the plan and did get my matching from the company as well. Typically when you take a "hardship withdrawal" not a loan, is where you run into potential tax penalties and not being able to contribute and or participate in the plan for an ammount of time specified in your plan. If for any reason you do take a loan and leave that company before the ammount is paid off you would need to pay the remaining balance in full or it is considerd a withdrawal and is taxed accordingly.

hope this helps, but you should check with your plan for specific rates and or penalties that there may be

 

[M 'n C]

I'm actually studying for the tax section of the CPA exam and you will get taxed twice on any distribution from your 401k which is not qualified. There is a 10% penalty assessed for the amount distributed and then you have to include it in your gross income where you will be taxed on it again and its especially bad if you are bumped into the next bracket because of it (not sure if that is your case).

Just an FYI qualified distributions would be in the case of:
1st time home buyer, Medical Insurance, Medical Expenses, Disability, College Education, and Death.

How about taking out a home equity loan on it? I believe based on my studying you can deduct the interest up to $100k on home equity loans that are not going towards home improvement which would be your car.

 

[janette]

Have you shopped for a regular car loan? What are the interest rates offered? Are the dealerships offering any special financing?

Almost all financial advisers will say not to use 401K loans, as with anything I think it can be used with caution.

1) One of the biggest reasons they always list is the assumption that if you take a 401K loan you'll use the money you were contributing to pay off the loan. If you'd have to do this it isn't a good idea.

2) If you leave the job you have to repay it usually very quickly or it will count as a distribution. A previous poster mentioned the downsides to that.

3) The interest is usually paid back into your account, you risk that you'll make less with the interest than the investments it would be in had you left your principal untouched. In rare cases this can work to your advantage, we used a 401K loan to help purchase our house 5 yrs ago. It was the summer before 9/11 and the accounts bottomed out during the next 2 yrs. Our return was actually higher from the loan than it would have been otherwise, this is usually not the case and as far as financial advisers they assume you'll have made more on the other investments.

Personally I'd probably opt for traditional financing on a car. The only time I'd consider a 401K loan is for something that would be considered unsecured or personal. For example you couldn't borrow money from the bank to use as a down payment on a house without securing it with the house. You can get it from the 401K and it is not considered debt as far as credit reporting, it also forces you to put the money back in savings where if you took a distribution even for a qualified reason you don't have to return the money.

 

[KJMAX1]

I personally would never use my 401k for several reasons. The first is that if you check you can get your car loan financed at a much lower rate than your 401k offers. Most loans if your credit is in decent shape is around the 3 to 5% range. Take the amount you want to borrow, and times that by the amount of money you earn each month off of it, and times that by the number of years until you retire. Your car could potentially be costing you 100,000.00 Remember your car depreciates, not appreciates. To me, its not worth it to buy a new car for that price. I would rather settle for a two year old car than lose that much money. You never know if you will ever desperately need it. A home equity loan is another option, however, I think you will find that a simple car loan from various lenders might be the best. Take those with you when you go to purchase your car, and negotiate your interest rate. Remember, everything when purchasing a car is negotiable, including your interest rate.

 

[jlima]

I would get a cash advance on a credit card to put a downpayment on a car before I'd touch my retirement. Don't do it.

 

[DisneyFanTN]

I am no expert but hopefully I have some helpful information for you. I actually process the prelim paperwork for our employee's 401k loans. Each company has their own policy and/or plan rules regarding loans. It is never recommended to touch your retirement plan; however, for a lot of people, that is the only source of money available to them. With our plan, you can borrow up to 50% of your 401k balance but our company specifies reasons you can take out a loan (auto/home purchase, medical expense, school) -- my husbands policy allows you to take a loan for any personal reason. Usually there is a processing fee which can be added to your loan. Because of the federal rate rising, 401k loans do have a high interest rate right now. The last one I did was 9% but I remember last year when it was only around 4-5%. You may find that some banks have auto loans under 6%. However, with the 401k loan, you are paying yourself back the interest, and you can choose the term of the loan (lesser is better). The payment then comes out each payday. As far as taxes or penalties, there are none for a qualified 401k loan unless your employment ends before paying your loan in full. With that said, it then would be considered a distribution so taxes and penalties would then apply. Also, you cannot take another loan until the first one is paid in full. Hope I helped a little. Definitely check with your employer regarding their specific rules/policy. Good luck!

 

[Cheshire Figment]

I am no expert but hopefully I have some helpful information for you. I actually process the prelim paperwork for our employee's 401k loans. Each company has their own policy and/or plan rules regarding loans. It is never recommended to touch your retirement plan; however, for a lot of people, that is the only source of money available to them. With our plan, you can borrow up to 50% of your 401k balance but our company specifies reasons you can take out a loan (auto/home purchase, medical expense, school) -- my husbands policy allows you to take a loan for any personal reason. Usually there is a processing fee which can be added to your loan. Because of the federal rate rising, 401k loans do have a high interest rate right now. The last one I did was 9% but I remember last year when it was only around 4-5%. You may find that some banks have auto loans under 6%. However, with the 401k loan, you are paying yourself back the interest, and you can choose the term of the loan (lesser is better). The payment then comes out each payday. As far as taxes or penalties, there are none for a qualified 401k loan unless your employment ends before paying your loan in full. With that said, it then would be considered a distribution so taxes and penalties would then apply. Also, you cannot take another loan until the first one is paid in full. Hope I helped a little. Definitely check with your employer regarding their specific rules/policy. Good luck!

I agree with everything DisneyFanTN said.

1. Read the information from your plan carefully.

2. If the plan allows you to keep regular payroll deductions (as well as employer matching) it is workable.

3. Be aware that if you leave that employer you will have a certain length of time (which can vary from zero up but must be no later than the end of the calendar year) to repay the loan or it will be reported to IRS as a premature distribution. Note the money, in this circumstance, must be received by the end of the year.

4. And the reason the interest is so high is the rate is designed to make up not only for the reduction in your balance, but also the lost earnings that would have accrued on that balance.

Mike (CPA)

 

[Benducci]

I'm actually studying for the tax section of the CPA exam and you will get taxed twice on any distribution from your 401k which is not qualified. There is a 10% penalty assessed for the amount distributed and then you have to include it in your gross income where you will be taxed on it again and its especially bad if you are bumped into the next bracket because of it (not sure if that is your case).

Just an FYI qualified distributions would be in the case of:
1st time home buyer, Medical Insurance, Medical Expenses, Disability, College Education, and Death.

How about taking out a home equity loan on it? I believe based on my studying you can deduct the interest up to $100k on home equity loans that are not going towards home improvement which would be your car.

This is correct IF you were taking a hardship distribution, which you are not.

A loan from a 401(k) is like borrowing from yourself. The reason the rate is currently so high is that the IRS/DOL looks fo the plan to get rates from comparable banks to set a rate. BUT they also allow the trustees to use the Prime Rate + 1 %. Prime is currently very high at 8.25%.

You will have to make your loan payments back from payroll, based on a 5 year payback. There will be most likely a fee to process the loan, we charge $100 to set it all up. You can continue to take your 401(k) deferrals from your pay.

The biggest thing is that, unless your plan stipulates otherwise (and seom plans do allow terminated participants to continue to pay loans after termination by check) you will have to pay the loan back immediately upon employment termination or the loan will be in default. Then there are issues.

I am a pension consultant/administrator. If you have any questions, please feel free to email me.

To be honest, the best loan would be from a home equity loan where at least you would get a deduction for your taxes.

 

[my3kids]

I would get a traditional car loan. Maybe look at auto financing through Costco. I wouldn't touch the retirement just because when you are driving it around it isn't growing for you for later. There has to be a calculator somewhere that shows what happens to 20K or whatever the amount is if it grows for X number of years versus if it grows, is removed, then put back later.

If I had a sick child who needed something and no insurance then I would do it. But for a car, I would go the traditional route.

One idea though. If by chance you have a whole life insurance policy. Replace that with amount with a term policy then cash out the whole life and use that money for the car.

 

[stemikger]

The way my 401K plan works is that you can borrow from it and pay yourself back. Everyone thinks this is the best way to go. But you are losing the time value of the money working for you. Also, if you get laid off or fired (guess what) you have to pay that loan back in full or get hit with heavy penalties. It is really not a good thing to do.

Go with a traditional car loan. Try to go with a 3 year loan if you can.

As a rule try to think of your 401K as untouchable. You can borrow to buy a car, a house or almost anything else, but you can't borrow a retirement fund.

Good Luck.

 

[ducklite]

Shop around, there are some low/no interest loans out there depending on the manufacturer. I used this to buy my last car, a Saturn ION. With a zero % interest loan, I financed it 100%. I SOLD my "trade-in" to the dealer, took that check and paid off DH's car loan. It actually reduced my car payment by $100/month, paid off DH's car, and I took a four year loan, because at 0% interest I figured "why not." I just sold that two year old car and walked away with about $1500 after the pay-off. Talk about a win-win!

Or depending on the equity you've got, think about the HELOC option. At least the interest is (probably) tax deductible.

Anne

 

[Laurajean1014]

I was always told NOT to do this. In theory it sounds good, borrowing from yourself, but I guess not many are able to pay it back and hence there are major issues with tax and government.

Also, if you get laid off or quit, my plan says you need to pay it back in 90 days. If I needed to borrow it, I probably would not be able to pay it back in 90 days after a layoff.

 

[Cyndiu]

When you take a loan from a 401(k), remember that you are withdrawing money that hasn't been taxed, but when you are paying it back, the payments come from taxed funds. So, not only do you have the loss of any potential income while the money is not invested, you also have the start-up fee (whatever that is for your plan), sometimes there are quarterly maintenance fees, the interest that you are paying, although it is back to yourself, but in most cases it'll be higher than the interest rate you can get from your bank or credit union.

You're better off getting a cheaper car loan (if at all possible) and increasing the 401k withholding by the difference in the money you are repaying to the bank vs. the interest you would have paid to the 401k plan.

Plus, there are some 0% financing deals on new cars right now.

 

[sdenis]

Don't do it! There are better options out there for getting money other than your retirement stash.

 

[dcfromva]

We are hoping to buy a new car sometime in the next week (or month ) and we are considering taking loan from our 401K to pay for it. (Sorry guys, we do not have the cash. Please don't yell. )

Please help me to figure this out. If we take the loan from our 401K, we will be paying 9.25% interest, which goes to back to us (I THINK).

Is there any good reason (other than maybe a lower interest rate which does NOT go to us) to finance another way?

BethR,
You need to read the rules for your 401K very carefully so you are aware of the pitfalls. In the case of my employer, it takes several weeks to process the loan so I know I couldn't buy a car next week with a loan from my 401K.

We are only allowed to borrow the actual contributions we have made, so that excludes any earnings or matches. There is a maximum amount of contributions that can be borrowed:50K (I think this figure is set by IRS).

Some pitfalls: If you don't pay the loan back, you are subject to taxes --and 10% penalty for early distribution (I am assuming you are under 59.5).

If I leave my employer, I have to pay back all the money on the loan or it is considered an early distribution. A question to think about: do you want to be tied to your current employer for X number of years (equal to the loan pay back time)? Most folks don't plan on leaving their employer, but what if it is due to circumstances beyond your control? (An accident or illness which leaves you unable to work at your present job).

Once a distribution has been declared in default (missed/late payments), you cannot repay your loan and it is considered an early distribution.

If you have an outstanding loan when you die, that amount is considered a taxable distribution to your estate. (In the case of death, your spouse has the option of rolling your 401K account balance over to his own IRA or other qualified 401k account to defer the taxes 'til his retirement instead of taking a distribution. Your spouse would not have the option to pay off the loan and roll the entire 401K balance over to his account. It would be the balance of the account minus the loan balance. )

Remember, too that if for some reason the loan goes into default or you leave your employment (and don't pay back the balance): the balance remaining is considered an early distribution and your employer has not done any withholding. At tax time, you would have to come up with ALL the resultant taxes and penalties!

I would not take a loan from my 401K unless there was no other way. I think you've picked a real good time to purchase a car because dealerships are in the process of getting rid of their "old"2006 inventory. You might be able to get a really good deal and a really sweet financing deal as well. What kind of car are you looking for?

-DC