The Rules: Understanding Your 401(k) 21 Warning! What if you can't pay back the loan? The tax collector is waiting because you broke the rules. The IRS says that if you fail to pay back the loan, you'll be in default. In other words, the outstanding balance will be treated as if you withdrew the money before retirement. You'll pay federal and state income taxes on this money, plus a 10 percent penalty. If a second loan is made available, it generally can be used only to purchase a primary residence (house, condo, co-op, or mobile home). In that case, the loan term can exceed five years. It's not unusual to see residential loan terms of 10, 15, or 20 years. Because of the large increase in loans, and partly to discourage you from taking them, more than 76 percent of 401(k) plans charge a loan fee. You'll pay perhaps $25 to $75 or more to set up the loan, and $10 to $50 every year to administer it. That's a very hefty fee indeed--particularly if you're borrowing small amounts of money. Here's an example of what to watch out for. If you borrow money for five years and you're charged $75 to get the loan and $25 per year to keep the loan, you paid a total of $200 to borrow from yourself. This money is gone. You never get it back. That's a 20 percent service fee (you should think of it as added interest) on a $1,000 loan. If your company charges a fee for loans, keep this reality in mind and borrow only on a limited basis and only in large amounts. Of course, if you are using the loan to pay off credit card debt, the 20 percent interest rate that you'll pay may be a good deal. Our Advice Before taking that 401(k) loan, consider your other options first, such as tapping the equity in your home through a second mortgage or by refinancing. By using your home, you can consolidate your nondeductible debt such as car payments, personal loans, and credit cards at a lower interest rate and deduct the interest. Like any consumer purchase, shop around and negotiate! Sometimes the loan fee is deducted from the loan proceeds. So, in effect, you're financing the loan fee in addition to the loan. The other way you might pay the loan fee is to have it automatically deducted from your account. And just in case you were wondering who gets this loan fee, rest easy: It's not your employer. This charge is usually levied by the record keeper to offset internal expenses. Not all loans are created equal. Some employers limit your loan to a specific purpose. We call these hardship loans. Just as the name implies, you can borrow the money only for a particular reason. The most common hardship loans are allowed for these reasons: