You may already have a pension plan in place, but you might have to borrow money prior to retirement for medical emergencies or sudden expenses. However, not all retirement plans will permit you to withdraw money in advance. When you borrow money from your own pension, it is different than when you borrow from any lender. So, applying for a 401(k) loan is something like borrowing from yourself.

Before applying for a 401(k) loan, it is important that you understand all the risks and consequences. When you fund a 401(k) plan sponsored by your employer, the money will continue to grow with years and can turn out to be a great safety net for you when you retire. But, when there is a financial crisis, as a case of personal bankruptcy, you are left with no choice. In such situations, applying for a 401(k) loan makes sense because it can offer you better loan terms than any bank.

1. Loan limits

The loan is going to be subject to some limits, meaning that there is a legal limit to the amount that can be borrowed. The law usually fixes this at 50% of the vested account balance. This balance is what you own and for this, you need to be with an employer for a stipulated period of time.

2. Repayment

The loan has to be paid back through payroll deductions. So, the repayments will happen automatically and the amount gets deducted from your paycheck. You can enjoy a maximum term of five years for repayment and the plans are typically structured as quarterly or monthly payments. According to some plans, you may not be permitted to make contributions to this plan when you are making repayments. In case you lose the job this loan becomes outstanding.

3. Interest rates

Interest rates on the 401(k) plan are decided based on the rules of this plan and it is usually fixed according to a formula. You have to pay this interest back to your 401(k) balance. In spite of this, your retirement savings tend to be affected when you take the 401(k) loans.

4. Withdrawing money

While some 401(k) plans will let you withdraw money like a loan, some will not. So before you apply, it is important to verify with your investment company or plan administrator whether or not you can borrow from the balance. It is not possible to borrow from an old plan if you are not working for that company anymore. You must also remember to use the borrowed money wisely. Studies conducted on this type of loan has revealed that nearly 39% of the loans are utilized for debt repayments while about 32% is used up for home repairs. Some even use it for paying for college tuition, automobiles, medical expenses, etc. You must be careful to not spend this borrowed money recklessly.

5. Late payments

If you make late repayments, these will be costly. You do not have to pay taxes when you take a loan, but if you fail to pay the money back on time, taxes may be due. When you quit the job while you have an outstanding 401(k) loan, the remaining balance can be considered a distribution.

6. Outstanding balance

Finally, if the loan does not get repaid according to the set repayment terms, any outstanding balance will also be considered as a distribution. This becomes taxable and in case you are not 59 and a half, an early withdrawal tax will also be applicable.