Taking a loan against your TSP has become a common practice with federal employees. Even federal employees with high incomes have taken money out of their TSP because they felt it was a “good deal.” As many of us have seen in life, just because it sounds like a good deal does not mean that it is. Despite sounding like a great opportunity to gain access to your money, I would like to offer four reasons as to why TSP loans are not a good deal and why you shouldn’t take one.
1. You aren’t earning anything on your loan balance.
If we look at historical averages, the stock market makes money more often than not. With that being said, when you take a loan out of TSP, you are not earning anything on the amount of the loan. For example, if you take a $20,000 loan and the market is up 10% over the next year, you just missed out on a gain of $2,000. It is also important to point out that the extra $2,000 would have generated more money (due to compounding) for the duration of the investment.
2. You are taxed twice on the amount of the interest.
Who enjoys paying more taxes than they have to? I can’t say that I know of anyone. If you prefer not to pay taxes twice on your income, I would suggest not taking a TSP loan. When you pay the interest back, you are making payments with after tax dollars, which means that you paid taxes on the interest that you are now paying back to your TSP. Then what happens when you take money out of your TSP during retirement? Yes, every dollar that comes out of your TSP is taxed again!
Looking at the example above, if an employee takes a $20,000 loan and pays $5,000 of interest, it will take significantly more to pay the loan back. For an employee in the 22% tax bracket, it will take over $6,400 of earnings to pay the $5,000 of interest off.
3. Your TSP is a retirement account not a bank account or an emergency fund.
The TSP is designed to be a retirement account and it should be treated appropriately. Treating your TSP like a savings account is one of the most common ways that individuals hurt their retirement. That means that your TSP is designed to provide a retirement income. Too often I see employees take loans to start a small business, help family members, buy a car, build a house and so on. Other non-retirement accounts should be used for these types of needs. Having a savings accounts or emergency fund and implementing some delayed gratification can provide the resources needed for the items above.
4. It is not cheap money.
This point is related to the first but slightly different. One misunderstood benefit is that employees believe they can borrow money at a super low rate, like 2%. This is in part true (the rate you pay is based on the G Fund’s earnings), but you are paying yourself back at around a 2% rate. Therefore, in this instance, you are not earning money on the loan (Point 1) and you are paying a very low rate back to your retirement savings plan. Two percent does not sound like a very good investment return when the stock market averages close to 10%.
What should I do?
If your retirement is a priority, it would be best to avoid TSP loans. There are extreme circumstances when a TSP loan makes sense; however, they are usually few and far between. The next time you consider taking a loan from your TSP, please consider alternatives such as the following:
- a loan from a bank
- refinancing your mortgage
- obtaining a home equity loan
- investigating other resources
- not taking a loan at all
The best way to avoid the need to take a TSP loan is to build your emergency fund as soon as possible. It is a good idea to have at least 3-6 months of living expenses saved in an emergency fund to help avoid the need of taking a TSP loan.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.