A TSP loan can be heaven sent in a pinch or even for a down payment. The interest rate is extremely low (about 0.75% as of September 2020) and the small amount of interest you do pay just goes back into your TSP account. What is not to like? Well, there are a few things you should know.
Opportunity Cost
The interest you pay on a TSP loan is the same as the G fund return when your loan application is processed. For example, right now the G fund is returning 0.75% and so that would be the interest rate of your loan. So assuming that the return of the G fund doesn’t change too much while you are paying off your loan, a loan will result in about the same amount of money as if that money had sat in the G fund during the loan duration.
The biggest problem with this is that inflation has been around 2-3% over the last few years. That means that after adjusting for inflation, investing in the G fund (or taking a TSP loan) actually loses money overtime. Most people need to invest (at least a portion of) their money in the C,S, and I funds so that their retirement savings can at least keep up with rising prices.
When someone takes a TSP loan, they forgo any growth (as well as the growth from that growth) that they would have had if they would have stayed invested. And over time, this can dramatically affect someone’s TSP balance at retirement.
Big Tax Bill
As many feds have found out (a little too late sometimes), having an unpaid balance on a TSP loan when you retire, quit, or leave for any other reason, will count as a taxable distribution. This can often push many feds into a higher tax bracket. Those that are in the most trouble are those that had already spent the borrowed funds and now must scramble to pay for the extra taxes. Also, for those that leave service before age 59 and ½, a 10% penalty may be applied to the unpaid amount as well.
Double Taxes?
When you contribute to the traditional TSP, you get a tax deduction today but will have to pay taxes on that money and the growth when you take it out in retirement. However, when you take a TSP loan, you don’t owe any taxes on that money right away but you technically do pay taxes on it when you repay the loan. This happens because you have to use after-tax dollars to pay back a TSP loan. And down the road in retirement, you will have to pay taxes again when you take the money out.
Some people make the argument that you are not technically paying taxes twice on the same money because new money is being introduced when you repay the loan. But regardless of who you look at it, you are going to pay taxes one extra time by taking a TSP loan.
Conclusion
As you can probably tell, I often try to discourage people from taking a TSP loan. In most cases, it is much better to get funds from another source so that people stay on track for retirement. That being said, TSP loans are not inherently bad and there may be times that they make sense. It is up to every federal employee (and every person for that matter) to educate themselves as much as possible about their decisions to make sure that they make the most sense for them.
