Editor’s Note: This column replaces an earlier version that included information that was incorrect. Federal News Radio and Walker Capital Preservation Group apologize for the error.
Why do we borrow from the Thrift Savings Plan (TSP) instead of the bank?
Well, a personal loan from the bank is going to be dependent on your credit score and will have a much higher interest rate than the TSP would charge you. In general, someone with a good credit score today is going to start around 10.94 percent, according to the Nerdwallet Personal Loan Calculator tool, on an unsecured loan, meaning a loan that doesn’t require collateral.
When borrowing from the TSP, you are borrowing your own money, there is only a $50 fee, it doesn’t impact your credit score, and you only pay interest equivalent to the G Fund’s returns (and you are repaying that interest to yourself). Not too shabby of a deal — but there are still potential pitfalls to be aware of before deciding how to go about obtaining your loan.
One issue with reaching into your retirement savings is that you sacrifice potential earnings. Your TSP is a long-term investment meant to eventually replace at least one-third of your paycheck for most FERS retirees. That’s an uphill struggle when whatever amount you loan is no longer in the account to grow and compound. But the interest rate that you are assessed on your TSP loan (which equals the G Fund’s return) is actually paid into your account, so if you originally pulled the loaned money from the G Fund then by the time you paid it off you would be “whole.”
But that only holds true if you had already had the money in the G Fund and intended to keep it there for the life of the loan. There is still the opportunity cost of missing market returns in the C, S, I, or L funds in any given year during which their returns outperform the G Fund. Over the last five years the C Fund has averaged 13.68 percent and the G Fund 1.81 percent, equating to approximately an 11.87 percent opportunity cost — higher than the hypothetical 10.94 percent loan interest rate on an unsecured personal loan from the bank.
But that won’t always be the case. Opportunity cost loss only exists when you choose the TSP loan in a bull market — like we have had since the Great Recession of 2008. So it’s important to realize that market conditions matter to a degree when reviewing your loan options.
There are also the highly pervasive misunderstandings about the tax treatment of TSP loans, ones that even I had temporarily held to be true. You may have seen planners cite one of the reasons that you should not do a TSP loan is that you will pay income tax twice on the amount that you borrow. First, the loan repayments are made with after-tax income (that’s once). Second, when you take those payments out as a distribution in retirement you pay income tax on them (that’s twice). Makes sense right?
Well, in reality, this is an oversimplified explanation of a complex concept that for many initially seems to “ring true,” as it did for myself and many reputable retirement resources, but mathematically it does not pan out (as is exemplified in this white paper study from the Federal Reserve Board). To be clear, there is no additional “double taxation” for utilizing a loan from your TSP or 401(k).
The other major concern with a TSP loan, though, is that it is only good while you are still employed by the government. It does not matter whether you were to get fired, or transfer to the private sector, or retire — if you have a TSP loan balance and separate from service, then the balance of your loan is treated as a taxable disbursement by the IRS. For some, a lump sum addition to their taxable income may bump them into a higher tax bracket. For others, they may have spent the proceeds from the loan and now have to scramble to come up with the surprise tax liability they incurred on the balance. Or for those unfortunate enough to find themselves separating from service with a TSP loan while under age 59 1/2, they not only have to pay the normal income taxes but will also face the 10 percent penalty for taking an early disbursement from a retirement account.
So as you can gather, there are a multitude of factors that influence the decision of selecting where to get a loan from such as; your credit score, the market climate, the interest rate environment, the political posturing, etc. There is no generic “right answer” that applies to everyone looking to borrow money. As a result, it is extremely important to understand your options fully and to avoid loans of any nature whenever humanly possible.
Tom Walker is a chartered federal employee benefits consultant and founder of Walker Capital Preservation Group, Inc. He has compiled many resources at his (www.WalkerCPG.com) website, and on the WalkerCPG Facebook page.