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Pros and Cons of Thrift Savings Plan Loans

Edward A. Zurndorfer, CFP - August 25, 2009

Before discussing the advantages and disadvantages of Thrift Savings Plan 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 TSP 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.

Posted: 08/25/2009

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Financial Consultant, Chartered Life Underwriter, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD -- and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  Zurndorfer is also is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.