The TSP Loan Guide, Part 2: Pros and Cons of TSP Loans
What are the advantages of Thrift Savings Plan loans?
(1) The interest rate is very low and you are paying it to yourself instead of to a bank. So the loan is essentially free to you, other than a small administrative charge.
(2) You avoid the 10 percent penalty on early withdrawals from retirement accounts. If you aren’t old enough, or are old enough but haven’t separated from federal service, you would have to pay this penalty if you withdrew the money outright.
(3) The fee charged for TSP loans is a very low, flat fee of $50.
(4) The TSP loan application is quick, easy and straightforward. No one is turned down for a loan assuming sufficient employee contributions and earnings. No credit check is required. Other types of loans require a more complex application process, a credit check and more fees.
(5) There is no negative impact on your credit score. A TSP loan does not appear on your credit report, because it is not really a loan (you are using your own savings). If a TSP loan borrower loses his or her job, retires or leaves federal service and is unable to pay off the loan balance, the unpaid balance will be classified as a distribution for which income taxes must be paid, but it will not show up on your credit report as a default.
What are the disadvantages of TSP loans?
(1) The most significant disadvantage is missed opportunity. The most powerful feature of a retirement plan like the TSP is the tax-deferred growth and compounding of earning. Removing funds from your TSP account can significantly affect its growth. The inevitable result will be a smaller TSP balance at retirement, which will impact the way that you live out your golden years.
For example, lets say you took out a $50,000 residential property TSP home loan at the current interest rate of 2.125% and paid it off over 15 years. At the end of those 15 years you would have paid back $58,500 (and earned an additional $950 in interest on the principal after you paid it back). Your nest egg would have grown by only about $9500 in 15 years, and nearly all of that money came out of your pocket. Compare that to $50,000 compounding at 10.6% (the stock market s average rate of return over the past 25 years). At the end of 15 years you would have $243,481.
(2) Potential tax penalty. If you fail to pay off a TSP loan, income taxes on the distribution will be due. An additional IRS early withdrawal penalty of 10 percent will be applied if the account owner is younger than age 59.5 at the time of the loan default.
(3) A TSP loan of either type is not a mortgage. Therefore, the TSP loan interest payments are not tax deductible, as they might be for a mortgage or home equity loan.
(4) If you leave Federal service, you must pay off the loan within 90 days of the date when your agency reports your separation to the TSP. Any unpaid balance will be reported as a taxable distribution
The Double Tax Myth of TSP Loans
In the Disadvantages section of most websites which address TSP loans, the authors usually blindly copy some original source which incorrectly stated that taking a TSP loan results in paying taxes twice because the TSP account holder is moving tax-deferred assets into the taxable realm and after-tax income must be used to repay the loan. Suze Orman popularized the notion while discussing 401K accounts (which have the same tax treatment as the TSP) and this myth is widely spread across the internet.
Let’s say you want to borrow $10,000 from your Thrift Savings Plan account for a year. The TSP G Fund interest rate at that time is 5%, which you must pay back to yourself. That $10,000 was a pre-tax contribution, so you never paid income taxes on it. You take it all out, leaving yourself with $10,000 in cash. You haven’t paid any taxes on that $10,000. You leave it under your mattress, and a year later pay back the same $10,000 plus $500 in interest. You still haven’t paid taxes on the $10,000. When you eventually withdraw the money, then you finally must pay taxes. So what was the only thing taxed twice? The part attributable to the $500. Not the $10,000.
Now, does it matter if during the year your brother took the original 10,000 and then later replaced it under your mattress with a different $10,000? The answer is no. As long as you pay back the $10,000, that is all that matters.
The only part that is taxed twice is the interest. And since you are paying yourself the interest, this small double-tax is really the only cost of doing this loan. Using the example above and assuming a 25% marginal tax bracket, that means you only got taxed an extra $125 on that $10,000 loan. This is the same as getting a regular loan with a 1.25% interest rate.