TSP loans can seem tempting, but they should be avoided if they can. Although you might think that “you’re borrowing from yourself,” or you’re “paying yourself interest,” or “the interest is lower than a bank loan,” TSP loans are usually not the best idea. Here are the top reasons why they should be avoided.
Contributions made to a traditional TSP account are deducted from a federal employee’s gross (pre-tax) salary. Once that money is taken out as a loan, it is paid back with after-tax dollars. At a 20% tax rate, $1000 would be paid back with $1250 (and that’s before factoring in interest).
You pay tax twice on the interest when you take out a TSP loan. Once the federal employee pays back the loan (with after-tax dollars), taxes have been taken but put back in a pool of money (your traditional TSP) that is considered pre-tax. So, when the fed retires and makes qualified withdrawals, the money will be subject to taxes for a second time.
If loan payments are missed, there is a grace period before the loan goes into default. Once that happens, the loan is due immediately. Any unpaid portion of the outstanding balance is considered income by the IRS and subject to taxes. If the TSP account owner is younger than 59½, a 10% IRS penalty is added on top of that.
On a related note, unpaid TSP loans have to be paid back within 60 days if the account owner decided to leave federal service. If not paid back in full in that timeframe, the loan will go into default and as detailed above, that can have costly tax consequences.
This point boils down to one thing – if money leaves your TSP account as a loan, it can no longer be invested in the markets and therefore any potential investment growth is missed. In other words, loan proceeds once withdrawn lose any earnings from interest, dividends, and capital gains until that cash is paid back into the TSP account.
With all of the being said, this is how TSP loans work. There are two types – general purpose and residential. General purpose loans have to be repaid in 1 to 5 years and do not require documentation. Residential loans can have a repayment period up to 15 years and documentation is required. The minimum amount that can be taken as a loan is $1000 and maximum that can be borrowed is the smallest of the following:
A TSP loan is taken proportionally from an employee’s traditional and Roth TSP accounts. Repayments are reinvested in the account’s selected contribution allocation. The interest rate is equal to the G-fund’s interest rate on the day that the loan was granted. For March 2024, this rate was 4.375%.
The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Serving Those Who Serve writers and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. 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. **
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