Consequences of Unpaid TSP Loans for Retiring Federal Employees

Federal employees who own Thrift Savings Plan (TSP) loans, either a TSP general purpose loan or a TSP residential loan, are aware of the fact that these loans have to be paid back within the term period agreed to by the TSP participant and the TSP. Most employees pay back their TSP loans via payroll deduction. This means that the loans have to be paid back by the time an employee leaves or retires from federal service. This column discusses the consequences of an unpaid TSP loan and what an employee with an unpaid loan can do to avoid the tax liability and possible IRS early withdrawal penalty associated with an unpaid TSP loan.

The TSP must declare a taxable distribution on the entire unpaid balance of a TSP loan including any accrued interest, if any of the following are true:

• The loan owner failed to repay the TSP loan in accordance with the loan owner’s loan agreement;

• The loan owner has missed a loan payment and has not submitted to the TSP the amount needed to bring the loan owner’s payments up-to-date within the required time period;

•The loan owner has not repaid his or her TSP loan in full upon separating from federal service.

The TSP allows a separated or retired employee 90 days from the day the TSP Service Office is notified of an employee’s departure or retirement from federal service to repay a TSP loan. Since it normally takes 30 days for the TSP Service Office to be notified of an employee’s retirement or departure date, the employee therefore has 120 days from his or her departure or retirement date to fully pay off the TSP loan.

What Are the Tax Consequences of an Unpaid TSP Loan?

Once the TSP declares a taxable distribution on the entire unpaid balance of a TSP loan, the IRS will consider the unpaid balance of the loan to be taxable income. In addition, if the TSP loan owner is under age 59.5 on the day the unpaid balance is declared a taxable distribution, then the loan owner will have to pay a 10 percent early withdrawal penalty tax on the unpaid balance of the loan, in addition to paying both federal and state income taxes on the unpaid balance. Once a taxable distribution has been declared, the loan is closed and the loan owner will no longer be allowed to repay the loan.

If any part of a TSP loan is associated with tax-exempt Roth contributions, then those contributions will not be subject to income tax or an early withdrawal penalty if the loan is declared as a taxable distribution. But the following conditions apply to Roth TSP earnings:

• If the taxable distribution associated with an unpaid TSP loan is declared because the Roth TSP owner separated from federal service, only the Roth TSP earnings that are not qualified will be subject to federal and state income taxes.

• If the taxable distribution is declared for another reason such as a default on a TSP loan, then the Roth TSP earnings included in the distribution will be subject to federal and state income taxes. This is true even if the loan owner has already met the conditions necessary for the Roth TSP distribution to be qualified.

Is There an Alternative to Paying Taxes on an Unpaid TSP Loan?

If a taxable distribution on the unpaid loan was declared because an employee separated or retired from federal service, then the departed or retired employee may be able to rollover the unpaid balance to a traditional IRA or to an eligible employer-sponsored qualified retirement plan. The following are specific rules concerning this rollover:

• The rollover must be performed within 60 days from the day that the taxable distribution is declared by the TSP; and

• If the TSP loan owner has already spent the loan proceeds, then the loan owner can still rollover the unpaid loan balance using other personal funds that have already been taxed. In other words, the loan owner will deposit funds into a traditional IRA or into a qualified employment plan (such as a 401(k) retirement plan) the amount that was declared as a taxable distribution.

The following example illustrates:

Vincent Varota, age 60, retired from federal service on Aug. 31, 2017 with an unpaid TSP loan balance of $27,500. Vincent did not pay off his TSP loan following the 90 days after the TSP was notified of his retirement. That is, as of Nov. 30, 2017 Vincent still had an unpaid TSP loan. Since the TSP was notified of Vincent’s retirement as of Sept. 30, 2017, the TSP declared a taxable distribution on Vincent’s unpaid TSP loan as of Dec. 31, 2017. Vincent has until Feb. 28, 2018 to rollover the $27,500 unpaid loan balance into a traditional IRA or into a qualified retirement plan in order to avoid paying federal and state income taxes on the $27,500 for calendar year 2017.

The TSP in Section 5 of the Tax Notice “Important Tax Information About Payments from Your TSP Account” (January 2018 version, 8-page PDF) discusses the advantages of rolling over the taxable portion of the unpaid loan to a traditional IRA, including avoiding any tax liabilities and the additional 10 percent penalty tax for early withdrawals. But the TSP is vague on the mechanics as to how such a rollover is performed and recommends that affected loan owners consult the IRS or a tax advisor for information and advice. The fact is that very few tax advisors or the IRS have experience in rolling over taxable distributions from an unpaid TSP loan.

The following is the recommended procedure to perform a proper rollover to a traditional IRA, as illustrated by the example above with Vincent showing a taxable distribution of $27,500 on his unpaid TSP loan as of Dec. 31, 2017.

[Editor’s note:  To view the example forms  1, 2 and 3 discussed below, download them here (3-page PDF)]

Vincent receives a 2017 1099-R from the TSP in January 2018 (see Form 1) showing a gross distribution of $27,500. Note that Box 7 is coded “7” meaning it is a “normal distribution” (because Vincent is over age 59.5) with the “gross distribution” (Box 1) and “taxable amount” (Box 2) the same amounts even though Box 2b is “Xed” meaning the taxable amount is “not determined”.  Note the “identification number” and “payer number” are fictitious as is “Vincent Varona”.

Vincent does in fact contribute the full $27,500 to a “rollover” traditional IRA before Feb. 28, 2018. The $27,500 comes from a savings account in which Vincent has already paid taxes. Vincent reports the rollover on a 1099-R worksheet (provided by Vincent’s tax preparation software) and shown on Form 2 (Form 1099-R Worksheet), line B1.  The result is that the $27,500 distribution is no longer taxable. On Vincent’s 2017 Form 1040 line 16 (Form 3), it should be noted that the word “rollover” is written on the left side of the form outside line number 16a, the $27,500 is listed in box 16a, and the taxable amount in line 16b is $0.

Because Vincent used after-taxed money to rollover the $27,500 to a “rollover” traditional IRA, the $27,500 should not be taxed once it is withdrawn from the IRA. To make sure that the IRS knows that after-taxed money was used to perform this rollover, Vincent needs to notify the IRS that the $27,500 was previously taxed. He does so by filing IRS Form 8606 (Nondeductible IRAs) with his 2017 tax return, entering $27,500 on line 2 of Form 8606. By following this procedure and adhering to the 60 day rollover deadline, Vincent avoids paying taxes on his unpaid TSP loan.

It is worth noting that had Vincent not performed a proper rollover of the $27,500 into an IRA, he would have to include the $27,500 as income on his 2017 federal and state income tax returns. Had he fully repaid the loan (using after-taxed money) within the 120 day period following his retirement from federal service, he will pay tax again on the $27,500 when he starts withdrawing the TSP. In other words, Vincent will pay income tax on the $27,500 twice; the first time by using already taxed-money when he repays the loan to his TSP account and the second time when he withdraws that money from his TSP account. This is the nature of TSP loans. A proper and timely rollover to a traditional IRA and filing of Form 8606 will therefore avoid double taxation on the unpaid TSP loan balance.

In the event of the TSP loan owner’s death, the outstanding loan balance plus any unpaid interest is reported as a taxable distribution to the TSP loan owner’s estate. The loan cannot be repaid by the estate or anyone else. The distribution is not subject to an early withdrawal penalty tax. But any non-qualified Roth TSP earnings included in the unpaid loan balance will be subject to federal and state income taxes.