TSP Loans: What Federal Employees Should Consider
Edward A. Zurndorfer, CFP
The national economy is suffering. Homeowners cannot afford their newly adjusted
mortgage payments, frequently resulting in foreclosures. Recently, the
stock market has suffered through one of its worst performances in several
years. Many banks have failed in the last year with perhaps more failures
to come.
As the housing, stock market and bank crises grip the country, many
individuals are turning to their retirement plans -- for example, 401(k) plans
and the Thrift Savings Plan (TSP) -- for financial relief. They are borrowing
from their retirement plans to pay their monthly mortgage, car loans and credit
card bills.
According to the Federal Reserve Board's Survey of Consumer Finances, loans
against retirement plans have increased from $6 billion in 1989 to $31 billion
in 2004, the last year with available data. It is most surely a much larger
number in 2008.
Before discussing the advantages and disadvantages of TSP loans, it
is important to review TSP loan rules:
- Only employees who are in pay status are eligible for TSP loans. Only
employee contributions and earnings - not agency contributions and earnings -
can be borrowed.
- Two types of loans are available - general purpose loans and loans in order
to purchase a principal residence. Loans to purchase to purchase a rental
property or a second/vacation home are not permitted.
- The minimum loan amount is $1,000. To be eligible for a loan, a TSP account
owner must have at least $1,000 of contributions and earnings on those
contributions in his or her account.
- The maximum loan amount is $50,000. But the maximum amount one can borrow
also depends on the individual's TSP contributions, any outstanding TSP loans
that the individual may have, and any limits set by the Internal Revenue
Service.
- The interest paid for the life of a TSP loan is the Government Securities
(G) fund rate at the time a TSP application is processed. The interest paid on
the loan is deposited into the loan owner's account along with repayments of
loan principal. A one-time fee of $50 covering the cost of processing and
servicing of the loan is deducted from the loan proceeds.
- Loans must be repaid - usually through payroll deductions - over the payment
period specified in the TSP loan agreement. To repay a loan more quickly, or to
make up for missed payments, TSP owners can pay by personal check or by money
order. There is no penalty for prepaying a TSP loan.
- All loans must be repaid before the borrower retires or leaves federal
service. If a TSP in not repaid, the TSP will declare a taxable distribution for
the balance of the outstanding principal and interest.
For many employees, TSP loans sound like a logical way to get some needed
cash to pay for unforeseen expenses or to help purchase a principal residence.
What are some advantages of TSP loans?
- Paying yourself interest. Paying a reasonable amount of interest to yourself
instead of an extravagant amount to a finance or credit card company would seem
to be a less expensive way for employees to borrow.
- Easy loan application. The TSP loan application is easy and straightforward.
No one is turned down for a loan provided there are sufficient employee
contributions and earnings. No credit check is required. Other types of loans -
for example, home equity loans, require a more complex application process, a
credit check and more fees.
- No credit repercussions. 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 the borrower's credit report as a "loan
default."
But there are some disadvantages to TSP loans, including:
- Paying taxes twice. By taking on a TSP loan, the account owner is moving
tax-deferred assets into the taxable realm. One must use after-taxed income to
repay the loan. For example, if an individual is in a 25 percent tax bracket,
the individual would have to earn $125 to repay every $100 in principal and
interest. After retirement, when the individual withdraws the same money used to
repay the loan, the individual will pay income tax again on the same
money.
- Sacrificing growth and losing ground .Perhaps the most powerful feature of a
retirement plan like the TSP is the tax-deferred growth and compounding of
earnings and contributions. Removing these assets from one's TSP account via a
loan can significantly affect the growth of one's account. Some borrowers have
to reduce or suspend their TSP contributions in order to repay the loan. The
overall result could be a smaller TSP retirement "nest egg", possibly forcing an
individual to postpone retirement in order to continue contributing to the TSP
to make up for any "nest egg" deficit.
- Potential tax penalty. If one fails to pay off a TSP loan, then income taxes
- federal and possibly state - 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.
Employees who are tempted to dip into their TSP accounts via a loan to meet
current needs should ask themselves: "Is my current need important enough that I
want to risk reducing my level income during retirement?" Perhaps it would
make good sense for these employees to talk to a financial advisor or tax
consultant before they borrow from their TSP accounts. A financial or tax
professional should be able to evaluate the effects of a loan and to make
suggestions for alternative ways to tapping into one's TSP retirement assets.
About the Author
Edward A. Zurndorfer is a Certified Financial Planner and Enrolled Agent
in Silver Spring, Maryland. He is also a registered representative with
Multi-Financial Securities Corporation (Branch A9X), member FINRA/SIPC, also
located in Silver Spring, Maryland
To read more articles by Ed Zurndorfer, go
here
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