While the 401(k) was designed as a retirement plan, there are ways to get your money out while you're still working. Some plans let you borrow money from your account for anything you want, including buying a car. Before taking a loan from your 401(k), make sure you understand the repayment terms. A badly handled loan can seriously derail your retirement plan and have tax consequences.
TL;DR (Too Long; Didn't Read)
If your employer's 401(k) plan offers loans and doesn't restrict what you use the money for, then you can borrow from your 401(k) to buy a car.
Basics of 401(k) Loans
Not all 401(k) plans offer loans. When your employer launched your company's plan, he decided whether or not to permit loans. You can only borrow money from your 401(k) if it allows loans.
If you can borrow from your 401(k), the IRS limits the amount you can borrow. You may borrow 50 percent of your vested amount up to a maximum of $50,000. If you have $100,000 or more in your account, you borrow up to $50,000. If you have $80,000 in your 401(k), you can only borrow up to $40,000.
401(k) Repayment Terms
You need to repay your 401(k) car loan within five years. If you don't, it will count as a withdrawal, and the IRS will charge you taxes and penalties. You also need to pay interest on top of the loan balance.
Your loan repayment schedule depends on your employer. The IRS requires you to make loan payments at least quarterly, but your plan may demand more frequent monthly payments. Some companies let you use an automatic payroll deduction to make your loan payments. This makes sure you never miss a payment and default on your loan.
401(k) Loan Advantages
A 401(k) car loan has several advantages over other types of debt. You don't need to pass a credit check to borrow from your 401(k), so you are guaranteed to get the money. A 401(k) loan also generally charges a lower interest rate than a regular car loan.
Lastly, you are paying your loan back to yourself. Both the interest and principal payments go back into your 401(k), so you'll have access to this money in the future. You're financing the car purchase yourself and not relying on a creditor, so you get the interest rather than a bank or your 401(k) plan administrator.
401(k) Loan Disadvantages
The biggest problem with a 401(k) loan is the cost of not paying your loan on time. If you don't pay your loan back, the IRS counts the loan as a withdrawal. You'll owe income tax on the entire loan amount, and if you are younger than 59 1/2, you'll owe another 10 percent penalty on the loan.
If you quit or lose your job for any reason, you'll need to pay back your loan in full within 60 days. If you don't, the IRS considers the loan in default and imposes the corresponding taxes and penalties,
A 401(k) loan may also come with opportunity costs. If the financial markets increase significantly, you lose the ability to make gains on the money you took out as a loan.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.