Can You Borrow From Your 401k to Buy a Car?

Borrowing from a 401(k) to finance a car purchase is generally permissible, though not universally available. The ability to do so depends on the specific rules of the employer-sponsored 401(k) plan and Internal Revenue Service (IRS) regulations. Participants must understand the conditions and potential consequences. This loan functions differently from traditional loans, as individuals are essentially borrowing from their own retirement savings.

Eligibility and Loan Amount Rules

Accessing funds from a 401(k) through a loan is not guaranteed, as plan sponsors have discretion. Many employers allow 401(k) loans, but review plan documents for availability and requirements. If permitted, Internal Revenue Code Section 72(p) limits the maximum loan to the lesser of $50,000 or 50% of the participant’s vested account balance.

An exception allows borrowing up to $10,000 if 50% of the vested balance is less than $10,000, though plans are not required to offer this. Vested refers to the portion of the account an employee fully owns; employee contributions are always 100% vested immediately, while employer contributions may have a vesting schedule. If a participant has an outstanding 401(k) loan, the $50,000 limit for a new loan is reduced by the highest outstanding balance over the preceding 12 months. Unlike hardship withdrawals, 401(k) loans do not require specifying the loan’s purpose, allowing flexibility for uses like car purchases. To initiate, apply through the plan administrator or provider, providing the desired loan amount within limits.

Repayment Terms and Process

Repayment of a 401(k) loan typically occurs through automatic payroll deductions, ensuring consistent payments from the borrower’s earnings. Most 401(k) loans must be repaid within five years. An exception for primary residence purchases allows a longer term, but this does not apply to car purchases.

Interest is charged on the loan, but it is paid back into the participant’s own 401(k) account, not to a third-party lender. The interest rate is commonly set at the prime rate plus one or two percentage points, ensuring commercial reasonableness. Borrowed funds are removed from the plan’s investments, meaning the money is no longer participating in market gains during repayment. This can affect the overall growth of the retirement account.

If the borrower leaves their job before the loan is fully repaid, many plans require the outstanding balance to be repaid by the tax filing deadline of the year following job separation, including extensions. If not repaid by this deadline, the outstanding balance is treated as a “deemed distribution,” triggering tax implications.

Tax Implications and Defaults

If a 401(k) loan is not repaid according to its terms, it can lead to tax consequences, as the outstanding balance is treated as a “deemed distribution.” A deemed distribution means the unpaid loan amount becomes immediately taxable income to the participant in the year the default occurs, effectively treating the loan as a withdrawal from the retirement account.

In addition to being taxed as ordinary income, if the participant is under age 59½ at the time of the deemed distribution, an additional 10% early withdrawal penalty applies under Internal Revenue Code Section 72(t). This penalty is imposed to discourage early access to retirement funds. The plan administrator will issue Form 1099-R to the participant, indicating the deemed distribution and its taxable amount. Even after a loan is deemed distributed and taxed, the participant may still have an obligation to repay the loan to the plan, and they generally cannot take another loan until the defaulted amount is satisfied.