Nov 21, 2024
Going through a divorce can seriously dry up your finances. Even if the process isn't dragged out in the courts, it could cost you thousands of dollars.
If you're 52 years old with an $11,000 legal tab to cover — and you have an individual retirement account — you may be considering a loan from your 401(k) if your plan provider allows for that option.
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While that might seem like a good solution to pay your legal fees, you should know that borrowing money against your 401(k) has some serious drawbacks. It's essential to weigh the pros and cons before casting a line into a new well.
How 401(k) loans work
A 401(k) loan works similarly to a traditional bank loan in that you borrow a sum of money and are then obligated to repay those funds on a schedule that your plan provider determines.
The maximum amount you can borrow with a 401(k) loan is 50% of your vested plan balance or $50,000 — whichever is smaller. If, for example, you have $90,000 vested in your 401(k), you can take out a loan of up to $45,000. You generally have five years to repay it, though there can be exceptions.
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The pros of taking a 401(k) loan
Taking a loan from your plan is better than taking out a withdrawal at age 52. The rule with a 401(k) is that distributions taken before age 59 1/2 are subject to a 10% early withdrawal penalty.
There can be exceptions to the rule if you separate from the company sponsoring your 401(k) in the calendar year you turn 55 or later. In that case, you can generally withdraw from that company's account without incurring a penalty if you're between age 55 and 59 1/2.
But with a loan, you're not taking a withdrawal. Instead, you're borrowing money. And if you pay back your loan on schedule, you won't face a penalty. Also, while loans do require you to pay interest on the sum you borrow, you're paying that interest to yourself, not a lender. So it's your account that gets to benefit from it.
Furthermore, you don't have to go through a credit check to qualify for a 401(k) loan. If you have poor credit, you might struggle to get approved by a bank, and you might get stuck with a high interest rate if you are approved.
There's generally no penalty for repaying a 401(k) loan early. Some loans impose a prepayment penalty that could cost you money if you shed your debt ahead of schedule.
The cons of taking a 401(k) loan
On the flip side, there are a few disadvantages to borrowing from your 401(k). First, anything you borrow cannot be re-invested during your loan period. You could miss out on big returns if you take out a loan during a period of substantial stock market gains.
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Granted, if you're in the process of repaying a 401(k) loan and you had no choice but to borrow that money in the first place, then you may not be able to afford contributions to your retirement plan anyway. Being unable to contribute could also mean missing out on your workplace matching your pennyworth.
There's also the risk of not repaying your 401(k) loan on time. If that happens, your loan is typically considered an early withdrawal if you weren't 59 ½ (or older) when you took it out. That could subject you to a 10% penalty on the amount you borrowed; plus a hefty tax bill.
While you generally have five years to repay a loan, that timeline is shortened if you separate from your employer. It doesn't matter whether you decide to switch jobs or you're laid off. Once you leave your employer, your loan balance will be due by that year's tax return deadline.
In other words, if you take out a loan in January 2025 and leave your job six months later, your balance will be due in full in April 2026 — when your 2025 tax return is due.
That's why it's important to consider the pros and cons of a 401(k) loan before deciding to borrow from it. That said, you may find there's a safer way to borrow that money, such as tapping the equity you have in your home or finding a personal loan with a competitive interest rate.
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Maurie Backman has been writing professionally for well over a decade. Since becoming a full-time writer, she's produced thousands of articles on topics ranging from Social Security to investing to real estate.
