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

[Stein]

I wouldn't. My first option would be cash for a used car. Second option would be a regular car loan for a used car. I always look at the "what-ifs" and if you loose your or find a better one, the retirement loan is due immediately.

I would also not consider any type of home loan, heloc, second, etc. If you can't make the payment on your car for some reason, you could loose your home. Plus, many of these loans are variable and have terms in the contract not so favorable to the homeowner.

I used an online lender several years back and received very prompt service, set the loan period to my liking and the interest rate was better than I could get locally.

 

[BethR]

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!

This is exactly the way that our plan works, but actually we can have TWO loans at the same time. And I can process it on line. I can process it today and have the check next week. It's a piece of cake.

The processing fee is only $25.

I know that if something happens to my DH's job we would have to pay it back immediately, but my DH has had this job for 25 years and things still look good (right now). But if worse came to worst, we could borrow from DH's parents, or do a HELOC then.

I suppose a HELOC would be a consideration, but aren't there fees associated with this? And then we would lose whatever interest we paid to someone else instead of to us.

I have looked at the financing they are offering through the car company that we are interested in and it isn't that great (and if you use the lower rate, you lose the rebates.)

I will check to see what our bank is charging for car loans, but I keep thinking, why pay someone else the interest when we can pay it to ourselves?

 

[sameyeyam]

That "New" car will be long gone and sitting in a heap in a junkyard by the time your retire. Then you will be sitting around wondering why you can't afford to retire, because you don't have enough money in your 401K.

It's always tempting to have a shiny new car, but the newness will wear off in a couple of months. Have you tried the GSA auctions? We just bought a 1999 Ford F350 crew cab 4x4 with only 43,000 miles on it for $12,000. Sure beats paying $40,000 for a brand new truck. Plus the GSA is the Federal Government and they have service records and keep pretty good care of their cars. They have a website and you can look at the cars and even bid online. I highly recommend them, check their websites every few days, because things change constantly.

 

[figment52]

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.

The OP isn't asking about a distribution but rather a loan. They are two different things.

A distribution is taxed when taken and cannot be paid back overtime (yes, you can increase future deferrals but that is not a pay back).

A loan is a non-taxable transaction that is paid back with after tax dollars and over time COULD become a distribution (and then taxable) if you terminate employment for any reason. Loans are "called" (payable now) usually withn 30-60 days of termination and then the balance is a taxable distribution.

Some plans are very specific about conditions under which a loan is available. Contact your HR department for specific plan information.

 

[CarolA]

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.

While I am pleased you are joining the ranks of the CPAs of this world your advice is no quite correct in this case. The OP wants to take a loan NOT a distribution. There are no tax impliacations on the loan. However, IF the OP was to leave thier job prior to repaying the loan then it does become a taxable distribution.

(Also, as a CPA I always preface my recommendations, by pointing out that a poster facing tax issues needs to consult thier CPA. Advice you get on here really is worthless. I don't mean that to be mean, but let's get real if you have to meet with the IRS do you really want to say "but the DIS boards told me it was deductible" or something like that! )

 

[dcfromva]

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.

M 'n C,
Folks need to be really careful with this one if they are subject to alternative minimum tax. Home Equity loan interest deductions for other than using the loan proceeds to buy, build or improve your home are thrown out under AMT. If a person is subject to AMT, this could be a real rude awakening at tax time...

-DC

 

[Ishy]

I used to program 401k systems. I would talk to the plan admin and read the rules for your particular plan.

Most will allow you to take a loan with no penalty and pay yourself back in interest and the payments are something you decide, typically for 5 years and Yes, you do pay yourself the interest. If it is for a car, especially for a used car, I dont think its a bad idea - also when you have the cash for a car, I have heard of some people getting insane deals because they offer the $$ they want to pay and are willing to walk away to the next dealership if the salesman doesnt jump at the offer. If for some reason, you loose your job, and you dont pay the loan in full at that time, some will allow you to continue to pay it if you can, but most will turn it into a withdrawl and then the balance is subject to the withdrawl rules.

All and all, I am not so down on this as others are. If you are buying a new car, you should try to get a 0% end of summer special - if what they offer you because of less them perfect credit is nasty --- 401k loan is not a bad idea.

Also - I never really heard of penalties for loans. Withdrawls yes. Loans no. It is also nice to have your payments spread out over your paychecks and automatically taken. One less bill to send out a month.

Good Wishes for whatever you decide and no, dont bother quoteing me and picking on what I said - I am simply stating my opinion, and I dont feel like debating - we can just say you win.

 

[BethR]

Good Wishes for whatever you decide and no, dont bother quoteing me and picking on what I said - I am simply stating my opinion, and I dont feel like debating - we can just say you win.

Well, I am quoting you none the less simply because you told me not to! And believe me, I am not debating you at at all. I think that generally (the part about bad credit isn't a factor with us at all! We have PERFECT credit! I just was not seeing any good rates being offered for the car that we are interested in - even for 2006s. So I was figuring, if we have to pay someone interest, why not pay it to ourselves?) we are in complete agreement on this.

 

[HayGan]

Well, I am quoting you none the less simply because you told me not to! And believe me, I am not debating you at at all. I think that generally (the part about bad credit isn't a factor with us at all! We have PERFECT credit! I just was not seeing any good rates being offered for the car that we are interested in - even for 2006s. So I was figuring, if we have to pay someone interest, why not pay it to ourselves?) we are in complete agreement on this.

Beth,

Taking out a 401k loan for the purchase of a car is bad idea unless absolutely necessary! While you will be paying your self interest you are actually losing money because those funds are no longer earning money for you!!! Say you borrow $20,000 and traditionally your fund has an annual return of 6% (which in many cases is a conservative figure.) By taking out that loan, you have lost out on $1,200 in the first year alone!!!! The longer it is out of your 401k the greater your losses due to that potential interest not earning interest. At least if you used the funds from a HELOC, those would be tax deductable!!! You can get a HELOC from your bank or reputable broker for litttle to no cost! (My DH is broker in the South Hills so I hear all about these!)

Please check with yor local bank or credit union to see what kind of rates you can get (often much better than dealerships.)

I hope I don't sound harsh but I think this would be a bad mistake. 401k loans should definitely be a measure of last resort and you have plenty of other much better options available to you!!!

 

[BethR]

Beth,

Taking out a 401k loan for the purchase of a car is bad idea unless absolutely necessary! While you will be paying your self interest you are actually losing money because those funds are no longer earning money for you!!! Say you borrow $20,000 and traditionally your fund has an annual return of 6% (which in many cases is a conservative figure.) By taking out that loan, you have lost out on $1,200 in the first year alone!!!! The longer it is out of your 401k the greater your losses due to that potential interest not earning interest.

OK, I am really slow understanding this. If we make 6% keeping the money in, wouldn't it be better to earn the 9.25% that we would be paying ourselves?

 

[Chicago526]

I know that if something happens to my DH's job we would have to pay it back immediately, but my DH has had this job for 25 years and things still look good (right now). But if worse came to worst, we could borrow from DH's parents, or do a HELOC then.

Actually, not to be a party pooper, but if your DH became unemployed, you wouldn't qualify for a HELOC. And while your DH's job looks secure, well, there are not guarantees in life, and I personally wouldn't want to start a potential length of time being unemployed having to pay back a 401k loan, just at a time when money is obviously is going to be tight to begin with.

At any rate, you should of course do whatever you feel is best and that you're comfortable with. Good luck with your car and loan shoping!

 

[HayGan]

OK, I am really slow understanding this. If we make 6% keeping the money in, wouldn't it be better to earn the 9.25% that we would be paying ourselves?

No because you are not earning the 9.25% - you are paying yourself that money. The 6% is earnings that you wouldn't otherwise have. Plus you have to factor in the earnings that the $1,200 would make in year 2 and what those earning would make in year 3, all the way through to the end of your fund! This loan could end up easily costing you more than $100,000 in your retirement savings (when you add up all the compounding interest that you will lose!!!)

Sure on the surface it sounds good to pay yourself interest but when you actually do the math you end up losing far more than you gain.

BTW, for a new car loan PNC Bank's rates are less than 8% right now (I don't know who you bank with but I'm sure that many others inthe area are equal or less than that )


I hope that you figure out a plan that works for you to get those new wheels

 

[disneysteve]

OK, I am really slow understanding this. If we make 6% keeping the money in, wouldn't it be better to earn the 9.25% that we would be paying ourselves?

Hi Beth. Sorry to be late to the thread. I've been engrossed in the "poor" thread.

If you borrow from your 401K, you aren't "earning" anything when you pay it back. You are paying that 9.25% out of your pocket. The money in your account earns 6% from the investments (and probably more than 6% in reality). It doesn't cost you a penny.

So as others have said, this is a bad idea. New car loans are 6.99% in your area (go to bankrate.com to find the specific lenders). So not only would you be losing money in your 401K, but you would be paying 2.25% extra interest for no reason. Bad deal all around.

 

[BethR]

Thanks everyone (particularly HayGan and Steve) for explaining this to me in baby language. I understand now. We wouldn't be EARNING the interest, we would be PAYING the interest. Got it.

So now I have to take a look for a good rate. We bank at S&T, so I will see what they are offering and take a look at Bankrate that Steve recommends.

I am glad that I asked you guys first. We can get the loan elsewhere, it won't be a problem. I will see what is the lowest rate that I can find.

Thank you EVERYONE for your input. I have learned something today.

 

[disneysteve]

So now I have to take a look for a good rate. We bank at S&T, so I will see what they are offering and take a look at Bankrate that Steve recommends.

What I've always done is this. Search around and find the best rate you can. The easiest/best way to do this today is bankrate.com. There you can search by city and state for local lenders.

Then, when you are at the dealer, see if their finance department will match the deal. They usually will because they make more money on financing than they do on car sales so they don't want to see you walk out the door to get your loan elsewhere. That way you get the best rate and get to take care of everything in the same place which is more convenient.

 

[BethR]

Then, when you are at the dealer, see if their finance department will match the deal. They usually will because they make more money on financing than they do on car sales so they don't want to see you walk out the door to get your loan elsewhere. That way you get the best rate and get to take care of everything in the same place which is more convenient.

That has been our experience in the past. We don't buy new cars THAT often (this will be our 3rd since 1993), but when we have gone in with a rate, the dealer was able to find a lender who can meet it.

We are looking at a 2006 Hyundai Sonata or Tuscon and they do have good interest rates, but if you take the interest rate, you lose on the rebate. Steve, is there a good method to weigh which would be better?

 

[disneysteve]

We are looking at a 2006 Hyundai Sonata or Tuscon and they do have good interest rates, but if you take the interest rate, you lose on the rebate. Steve, is there a good method to weigh which would be better?

Bankrate.com has a calculator for this too.
http://www.bankrate.com/brm/calc/rebate.asp

 

[BethR]

Bankrate.com has a calculator for this too.
http://www.bankrate.com/brm/calc/rebate.asp

Cool! Thanks!

 

[Bo'sMom]

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.

That would be good information if she was asking about taking an early withdrawal, but she's asking about taking a loan on it. She will not incur any tax penalties for taking a loan on her 401. All the interest on the loan will be paid back to her and in most cases she will also be able to contribute to the 401K while the loan is outstanding.

 

[BethR]

She will not incur any tax penalties for taking a loan on her 401. All the interest on the loan will be paid back to her and in most cases she will also be able to contribute to the 401K while the loan is outstanding.

That would be correct. There are no tax penalties. We would collect the interest. We can continue to contribute to our 401k during the length of the loan.