By Hank Coleman
Like a conventional 401(k) retirement plan in corporate America, members of the military and federal government employees can withdraw a portion of their tax deferred retirement plan in the form of a loan. Government employees can invest in the federal Thrift Savings Plan, which allows them to invest in index funds with before-tax dollars and later pay taxes on withdraws in retirement.
The plan also allows investors to take loans out against their retirement plan’s value, but there are several distinct advantages and disadvantages for doing so.
There are two types of loans that you can request from your Thrift Savings Plan: General purpose and residential loans. A general purpose loan can be used for any reason or for any purpose. The general purpose loan requires no paperwork on the part of the borrower and must be repaid over the borrower’s choice within one to five years.
A residential TSP loan must only be used for the purchase or construction of the borrower’s primary residence, requires documentation about the home, and payments can be stretch out up to 15 years. A member of the military or a federal employee can only have one outstanding general purpose loan and one outstanding residential loan from any one TSP account at a time.
A Thrift Savings Plan loan can provide a good backup for an investor’s emergency fund. Many Americans do not have an adequate emergency fund of three to six months of living expenses in place, and a TSP loan can provide a backstop in case of financial hardship. While it is not a perfect situation, having the option of a TSP loan can provide some cash strapped families with a certain amount of peace of mind in the event of an emergency.
Unlike many traditional 401(k) retirement plans in corporate America, a borrower can continue to make contributions to his or her Thrift Savings Plan while repaying the loan. If an investor wanted to do so, there is an option to recalculate the repayments to the loan in order to repay the loan quicker.
So, for example, if you have a $300 per month loan repayment for three years but are also making an additional $200 contribution every month, the investor can basically refinance the loan in order to pay it off sooner than originally planned.
When an investor takes out a loan from his Thrift Savings Plan account, the investor is essentially borrowing money from himself. He is borrowing from his retirement, of course. The interest that is paid as the loan is repaid is replaced back to the investor’s TSP account and not paid to a bank or other financial institution. The interest rate on your TSP loan is the G Fund rate at the time your loan application is processed. This rate is fixed for the life of the loan, and the interest is not tax-deductible even if used for a home purchase or down payment.
The worst drawback of a TSP loan is the amount of lost earnings in the future. When an investor takes out a TSP loan, he sacrifices the earnings that the account would have accrued on the borrowed money if it had remained in the TSP account. The loss of future earnings could quite possibly be rather large depending on the rate of return lost.
A $30,000 loan would have earned slightly over $7,000 in interest and capital gains over a three-year payback period assuming your investments earned an 8 percent annual rate of return while your money was tied up with the loan.
Lost interest early in an investor’s career could be especially costly. Lost interest of $3,000 from a TSP loan of a 30-year-old can result in the loss of over $44,000 worth of future compounding earnings by the time he is ready to withdraw it in retirement at the age of 65.
Like all 401(k) loans, a borrower will be required to repay the entire outstanding loan balance if he leaves federal service or the military. If you quit working for the government while a portion of your loan is still outstanding, you will only have 90 days to repay the entire amount. If you do not repay the loan, it is like a default.
While defaults will not harm your credit score, they are treated as a distribution. If you are not 59 and a half years old or older, the money is then taxed and you must also pay the 10 percent early withdrawal penalty.
Just because an investor can borrow money from his or her retirement account does not necessarily mean that it is a good idea. There are many drawbacks to the idea of taking out a TSP loan despite the flexibility that the loan offers investors. Plan participants must weigh the pros and cons to the loan and make plans only after careful consideration.