Ed Zurndorfer explains why TSP loans should be avoided, if possilble.
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Thrift Savings Plan (TSP) participants who are considering applying for a TSP loan for whatever reason should make every effort to avoid the loan. This column discusses the reasons why TSP loans should be avoided.
It is important to first present TSP loan rules. There are two types of TSP loans, namely: (1) General purpose loans with a repayment period of one to five years. No documentation is required, and (2) Residential loan with a repayment period of one to 15 years. Documentation is required. A residential loan can be used only for the purchase or construction of a primary residence. The residence can be a house, condominium, shares in a cooperative housing corporation, a townhouse, boat, mobile home or a recreational vehicle but it must be used as the TSP participant’s primary residence. TSP participants may have only one general-purpose loan and one residential loan outstanding at any one time. This is a per-account limit. If a participant has both a civilian account and a uniformed services account, then the participant may have one of each type of loan for each account.
Minimum and Maximum Loan Amounts
The smallest amount a TSP participant can borrow is $1,000. The maximum loan amount a TSP participant may borrow is the smallest of the following: (1) The participant’s own contributions and earnings on those contributions in the TSP account from which the participant intends to borrow (civilian or uniformed services). This does not include any outstanding loan balances; (2) 50 percent of the participant’s total vested account balance including any outstanding loan balance, or $10,000, whichever is greater, minus any outstanding loan balance; and (3) $50,000 minus the participant’s highest outstanding loan balance, if any, during the last 12 months.
Where the Loan Comes From and Is Repaid To
A TSP loan is disbursed proportionally from a traditional TSP and a Roth TSP account. If the TSP account is invested in more than one fund, the loan is deducted proportionally from the employee contributions and earnings on those contributions that the TSP participant (the loan borrower) has in each fund.
When the loan is repaid, the loan payments including interest are deposited back into the traditional TSP and Roth TSP accounts in the same proportion used for the TSP loan disbursement. Repayments are invested in TSP funds according to the TSP participant’s contribution allocations.
Interest Rate
The loan interest rate for the life of the loan will be the G fund’s interest rate that is in effect on the date that the TSP loan agreement is generated.
Why TSP Loans Should Be Avoided
There are four reasons that TSP loans should be avoided. These reasons are explained below. Since most TSP participants have contributed over the years, mostly if not entirely to their traditional (before-taxed) TSP accounts, the assumption is made that TSP loans are coming from the traditional TSP account.
- Reason #1. Contributions that have been made to the traditional TSP are deducted from an employee’s gross salary. That is, from salary that has not been taxed. Once that same salary is taken out in the form of a TSP loan, the loan borrower (the TSP participant) will pay the money back with after-taxed dollars, namely the dollars that arrive in one’s bank account via payroll.
- Reason #2. TSP loan proceeds are taxed twice. The first time is when the withdrawn loan proceeds (the before-taxed principal consisting of a TSP participant’s contributions and earnings) are paid back with money coming from the TSP participant’s bank accounts, which have already been taxed. The second time is when the TSP participant retires and withdraws from his or her TSP account, the participant will pay full tax on the amount withdrawn. The amount withdrawn consists partly of the TSP loan proceeds which were paid back with after-taxed dollars.
- Reason #3. The TSP will have terms for making up for missed loan payments if a TSP participant misses a TSP loan payment. This is called the “cure” period. But missing payments beyond the “cure” period and the TSP participant will be considered in default of his or her TSP loan. Once the TSP participant is in default on his or her TSP loan, the IRS will consider the unpaid loan balance as income and the TSP participant will have to pay income tax on the unpaid balance. Additionally, if the TSP participant is under age 59.5, the loan will be considered an early distribution and there will be a 10 percent penalty on the balance.
- Reason #4. If the TSP participant leaves or retires from Federal service with a TSP loan, he or she has up to 60 days from the day of departure or retirement to repay the loan in its entirety. If repayment is not made in full, then the participant will face the same tax and penalty consequences as a participant that had defaulted on the loan.
Another possible reason to avoid TSP loans that is not discussed here is the fact that the loan proceeds once withdrawn will lose any earnings (interest, dividends, and capital gains) on these proceeds until the proceeds are paid back.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
