Understanding TSP Loans
One of the good points of the TSP plan is the ability to take loans. You can put money into your TSP, build up a decent value and if you need a loan for a primary home purchase or other reasons you can get a loan from your TSP account. There are some requirements and rules you must follow to avoid being hit with penalties but those rules are relatively straight forward. You can take a loan from your TSP but should you? That question is one that we will delve much more deeply into further on in the post.
The ground Rules.
When employed by the federal government as a military member you are allowed take a loan out against your TSP balance. The minimum allowed for a loan is $1,000 and generally the maximum is $50,000, specific maximums apply depending on the balance of your TSP. The loan is repaid by payroll deduction, therefore it is necessary for you to currently be in a pay status in order to obtain a TSP loan. If you leave federal service with a TSP loan outstanding, you have 90 days after separation to repay the loan plus any accrued interest. If you do not pay the loan with 90 days in full, your loan will be declared a taxable distribution. That amount will then become subject to income taxation (Not the amount that was a Roth) and penalties. Instead of paying the loan off, you can roll that payoff amount into your new employer sponsored plan and avoid the taxation and penalties.
The TSP does charge a fee for loans. The fee is $50 and covers administrative expenses. It is deducted from your loan amount. So if you take a loan of $1,000 you only actually get $950 after the fee is deducted. The other main fee is the interest that is charged on the loan. The TSP loan interest amount is the G-fund rate at the time the loan is processed. This interest is fixed throughout the life of the loan. The interest is not deductible but is added to your overall account balance. Finally, there are 2 types of TSP loans 1) General Purpose Loan and 2) Residential Loan. The main difference between the 2 is the term. A general purpose loan can have a term as long as 5 years, a residential loan gets an extended term for up to 15 years. The residential loan is also a little more restrictive. It can only be used for the following purposes;
- A residential loan can only be used for purchasing or constructing a primary residence, which may be any of the following:
- Shares in a cooperative housing corporation
- Mobile home
- Recreational vehicle
- A residential loan cannot be used for:
- Refinancing or prepaying an existing mortgage
- Construction of an addition to an existing residence
- Renovations to an existing residence
- Buying out another person's share in the borrower's current residence
- The purchase of land only
The Advantages of borrowing from Your TSP.
A TSP loan is a relatively quick and painless affair. The application process is online and generally you can expect the loan paperwork processed and funds distributed within the week. Additionally, you are paying yourself the interest instead of paying to a bank. Largely the loan is free to you minus the $50 administrative fee. If you were considering removing the funds from the account even if there was no loan program you save on the 10% penalty had you withdrawn the funds outside the TSP loan program. Finally, there are no worries about getting qualified.
As long as you meet the general requirements for the loan the decision will be painless.
The Disadvantages of Borrowing from Your TSP.
There are some valid reasons why it may be a bad idea to take a loan from the balance of your TSP, even if you have the option. When withdrawing pre-tax dollars from your TSP you have to pay the loan back with after-tax dollars. This is probably transparent to most as it gets into understanding the nuances of taxes, but essentially if you take $1,000 out of your TSP pre-tax, and pay it back with after-tax dollars you actually have to earn $1,280 if you are in the 28% tax bracket. Another disadvantage when withdrawing money out of the TSP is you lose the advantage of the tax deferred investment. So that $1,000 loan you take out does not earn tax- deferred income until it is payed back. So now you have to pay back $1,280 plus you forgo any tax deferred growth that occurred during that period. Finally, you may desire to leave federal service. If you leave you will have to pay that loan back within 90 days. Not doing so could cause taxes and penalties to be assessed. So on that $1,000 loan, if you leave service and do not pay the amount back, you could be subject to income taxes of about $280 plus a 10% or $100 penalty. So the value of that $1,000 loan is now worth about $620.
How to Apply for a TSP Loan.
Applying for a TSP loan is done electronically, via www.tsp.gov. Log into the secure My Account section. Depending upon your marital status, type of loan, and how you want to receive the loan payment (by check or direct deposit), you will complete the process online or you will be required to print out the partially completed form, complete the form manually then mail or fax it to the TSP (with any additional required information).
The TSP loan is a very valuable benefit of the TSP retirement plan. It allows access to those funds to use for other purposes without penalty and a fair interest rate. Avoiding the pitfalls and ensuring you follow the regulations will ensure you do not end up being subject to additional taxes and penalties.