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When someone in their retirement is purchasing a car, is it financially more efficient for them to take a lump sum of cash out of a deferred-tax retirement account (and pay income tax on it), or is it better to finance the purchase?

Given the following:

  • $200,000 in a deferred-tax retirement account (say in a 60/40 bonds/stocks portfolio)
  • $20,000 used car purchase price
  • 5% finance rate
  • 4% SWR (safe-withdrawal rate) taken as income from the retirement account
  • Sales tax not included in calculations

Cash Purchase

In the case of the cash purchase

  • $24,000 is withdrawn from the account since 20% is immediately withheld, resulting in $20,000 used to pay for the car at once.

In this case, there's the income tax as one factor.

There's the immediate hit to the account resulting in a decreased SWR monthly:

  • $200,000 * 4% = $8,000/yr = $667/month
  • $176,000 * 4% = $7,040/yr = $587/month
  • $80 less per month of average income

There's also the opportunity cost of the $24,000 not growing anymore for, say 30 years.

  • $24,000 @ 7% interest for 30 years = ~$194,000

Finance

In the case of financing the purchase

  • $5,000 is withdrawn from the account since 20% is immediately withheld, resulting in $4,000 used for the downpayment on the auto loan.
  • A rate of 5% APR

In this case, there's less immediately lost to tax, and SWR is impacted less.

  • $200,000 * 4% = $8,000/yr = $667/month
  • $195,000 * 4% = $7,800/yr = $650/month
  • $17 less per month of average income

But it is now balanced by the car payment:

  • $20,000 loan
  • Term length: 60 months
  • Interest rate: 5%
  • Down payment: $4,000

Results in:

  • $372/month payment for 5 years
  • $2,371 total interest paid

So a total less in monthly income:

  • $650 - $372 = $278 monthly income for 5 years. But the full SWR rate after that

Problems

This is where I get lost:

  • I'm not sure how to calculate the opportunity cost lost
  • I also understand that the income used to pay the car note will have had income tax applied to it as well

Conclusion

If anyone else has done this calculation or if the whole SWR is irrelevant and I should just look at any old "cash vs loan" calculator to decide.

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  • 1
    How much are you contributing to retirement now (regardless of match)? How much do you have in savings? Can you afford the car payment with cash flow now?
    – D Stanley
    Nov 10 at 23:05
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    In general, borrowing from tax-deferred retirement funds should be a last resort.
    – keshlam
    Nov 11 at 0:05
  • @DStanley is right: we need to know how much you’re currently contributing. For example, you could reduce your contribs to the “minimum full company match” rate, and then use the extra money to pay the loan faster.
    – RonJohn
    Nov 11 at 2:15
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    This would be for someone currently in retirement and withdrawing from a 401k at a SWR or 4% or so. Not for myself. Withdrawals from 401k have 20% withholding off the top
    – Keith
    Nov 11 at 3:54
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    That “withholding” is because the withdrawn money is bog-standard taxable income. I’d fire up a spreadsheet and compute my estimated bottom line in X years for each scenario.
    – RonJohn
    Nov 11 at 9:53

3 Answers 3

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This is a good question that highlights how expense planning differs in retirement.

If you only have pre-tax retirement accounts (401k, traditional IRA) then an important consideration will be if a larger withdrawal will be taxed at a significantly higher rate. For example, if your taxable income was normally at the top end of the 12% bracket then the extra withdrawal would face 10% more tax. There's also an 8% jump from the 24% bracket to 32%. You'll want to evaluate the tax consequence of a larger one-time withdrawal vs the 5% loan rate over 5 years.

If a one-time extra withdrawal does not carry a significantly higher tax rate, or if you'd incur the same net tax over 5 years due to an increased monthly draw to cover the car payment (i.e. you're at the top end of the 12% bracket anyway, so whether you withdraw full car amount now or you'd have to withdraw extra to cover car payments and that extra would all be subjected to the higher tax rate), then there's no compelling reason to take a 5% loan in my opinion. If the extra one-time withdrawal would be taxed at a significantly higher rate, but the extra annually to cover loan payments would not be taxed at a significantly higher rate, then a car loan can make sense.

Beyond that, you have to decide if a guaranteed saving of loan interest is better than the potential investment returns. It's a relatively small amount of money and a 5-year timeline, so the difference in approach is not going to be that huge.

A good way to achieve greater flexibility in retirement is to have a mix of pre and post-tax retirement accounts so that you have some funds you can withdraw without tax consequences.

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  • This is a great response, thank you. Good point about the tax brackets.
    – Keith
    Nov 12 at 3:15
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If anyone else has done this calculation or if the whole SWR is irrelevant and I should just look at any old "cash vs loan" calculator to decide.

There are questions on this site that discuss loan vs cash to purchase a car. But in many of those situations the cash is sitting in their bank account, earning some interest. Answers focus on emergency funds, getting a cheaper car.

The twist is that you are retired and the "cash" is in an account that will trigger a taxable event. The answer requires looking at your entire financial picture. If the withdrawal of the $24,000 severely depletes the total balance of your retirement accounts that means pulling the funds from those accounts impacts your monthly income for years.

That leads me back to looking at the value of the car you are buying.

Some people have the goal that during their working career their first car will be via loan, the second only partially with a loan, and then eventually all cash for the rest of them. They achieve this by putting funds aside so that when they need to replace a car they have the cash.

Since in your case it would cost you money and monthly income to get the funds from the account, I would look at a less expensive option, and see if the loans available to you would work. Another concern about the loan would be getting it approved. If your monthly income isn't large enough to get a decent loan you might be looking at a longer term loan, or a higher interest rate to protect the lender.

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  • Thank you. SSI would be roughly $2,000 so good point about even getting a loan.
    – Keith
    Nov 12 at 3:16
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I think you're making this more complicated than it needs to be.

Let me set this up by answering two questions that you didn't ask. :-)

  1. I have cash in a post-tax account that is receiving 0% (or trivial) interest. Should I withdraw from this account to pay for a car or take a loan?

This is a (mostly) easy question. If you buy the car from this account, it costs you $0 on top of the cost of the car, compared to whatever interest you would pay on the loan. Clearly, you save money by withdrawing from this account.

The only caveat would be the possibility that you might need the cash for some emergency, and if that happened that your alternatives at the time would be more expensive than the car loan.

  1. I have money in a post-tax investment account. Should I withdraw etc?

In this case the question would be what return you are getting on the investment account versus the interest rate on the loan. If the loan will cost you 5% and the investments are returning 6%, you are better off to get the loan. Use the profits on the investments to pay the interest on the loan and you will still be 1% ahead.

The catch to this is that interest on a car loan is usually fixed, while return on investments is highly variable and unpredictable. Historically, the stock market returns an average of 7% per year, so you PROBABLY would be better off to leave the money in your investment account and take the 4% loan. But you can't rely on that. So it becomes a question of how much you want to gamble.

So now to your real question: You have a pre-tax retirement account, etc.

By getting the loan, you have to pay 4% interest.

By withdrawing money from the retirement account, you will: (a) Pay income tax on the amount withdrawn. As you're withdrawing a non-trivial amount of money, this will likely be in a higher tax bracket than you would pay if you withdrew the money at your normal rate. (Whatever that rate may be.) (b) Assuming this does push you into a higher tax bracket, not only will the money withdrawn to buy the car be in the higher bracket, but you may no longer qualify for income-based deductions, etc. (c) You will forfeit the profits you might have made on the investments.

I don't know what tax bracket you're in so I can't calculate the numbers. As I write this the stock market has been in a slide so returns are negative, but who knows what will happen in the next few years? (What's relevant is the period of time that the loan would last.)

Just suppose, to make up numbers, that you are normally paying a 10% marginal tax rate, but withdrawing this additional money will push you into a 12% marginal tax rate. Then you will pay 2% more tax on the money withdrawn then you would if you left it in the account and withdrew it more slowly over a period of years. As I say, I don't know your tax bracket. Looking at 2022 tax brackets, the worst case would be if you're taxable income without this withdrawal was $41,775. Then you'd be paying 12%, but the extra withdrawal would be taxed at 22%, for a 10% extra cost. Depending on just where your numbers land, it might not move you into another tax bracket at all, and so while paying the tax now rather than later may seem painful, the real tax cost is zero. But somewhere between 0% and 10%. Which is quite a range.

If you are already in the top tax bracket and expect to be indefinitely, then the tax implications would be zero. But if you were in the top tax bracket you probably would be asking your team of personal accountants this question rather than a bunch of strangers on the Internet!

The amount withheld when you withdraw the money is mostly irrelevant. If it's more than you owe in tax you're going to get a refund anyway and if it's less you'll have to pay the difference. The only difference it would make is if the calculation is close enough than you're considering how much you might make on investments in the period between when you withdraw the money and when you file your taxes. That is, if the withholding is high, you'll have less cash between the day you pay it and when you file your taxes, which creates some opportunity cost.

Historically the stock market has returned about 7%. If you used that as your benchmark, then even with zero tax cost, you're forfeiting a 7% investment return versus paying 4% interest. Better to pay the interest.

Monthly payments in any scenario are irrelevant. What matters is total cost one way or the other.

So all that said ... I was in exactly the same position a couple of years ago. I wasn't retired yet but I had plenty of cash in an investment account to pay for a car I wanted to buy. So the question was, Do I withdraw from the investment account and pay the opportunity cost of lost returns on investment, or take a loan and pay the interest? I figured, if the average return on my investments is 7%, and Ford was offering me a loan at 3% interest at the time, I was better off to take the loan. If I had been retired and there were tax implications on top of that, that would have been more reason to take the loan.

As I said, there's the uncertainty with investments versus a fixed loan rate, so a cautious person might prefer to pay cash.

Oh, one other thing to consider: The hassle of having to deal with loan payments. It's extra paperwork every month, if you forget to make a payment you could get hit with a late fee, etc.

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