Recently on FedSmith, I outlined scenarios for a TSP loan and when it might be an effective planning tool, or at least not the horrific event that it is sometimes assumed.
Just as stated in the article, loans from a retirement plan, or going into debt in any form really, is meant as a form of last resort. But what if there is an emergency? Or an inability to meet a past due obligation due to a major medical expense for example? Or even just the opportunity to swap an extremely high interest rate loan for one through the TSP that is comparatively very low; is it ever a good idea?
The article outlined the cash flow involved in paying back the TSP and tried to determine if one would come out even or possibly ahead depending on the circumstances.
One reader raised a good point, and I always enjoy receiving feedback through the comments on my articles or via direct contact. He said that lost in my analysis was the fact that you would be paying the TSP loan back with after tax dollars. This is true if you take out a loan and set up the payment plan to repay those payments; they will occur after taxes are calculated on your income.
So should the tax due on the income that is used to repay the loan be factored into the calculation to determine whether it’s a good idea? And are you effectively losing the tax deferred status on this money by taking a loan?
Although it’s important to understand taxes in everything you do from a cash flow standpoint, the fact that you are repaying a TSP loan with after tax money only makes it equal to, not worse than, most other debt you might be taking the money to restructure or pay off. In other words, if you are using the money from the loan to pay off a medical expense, 20% interest rate credit card, IRS debt and so forth, these amounts would have to be paid with other after tax dollars anyway.
Let’s address the second point here of whether you are losing the tax deferred status. Step one of a loan is first actually having money available in your TSP from which to borrow. This is only possible by contributing to the program over time, and these contributions are done pre-tax. At least most are through non-Roth contributions.
Let’s say for a moment these contributions are done in the year 2014 and reduce your tax liability. There might be several years of deductible contributions, but for our purposes we will use 2014.
In 2015 you take a loan and receive funds out of TSP without a tax consequence, and then pay back these funds with after tax money. To pay them back with pre-tax money would be to receive tax deductions in two years on the same amount. This isn’t the case of course; they go back in after tax and then are taxed as income when they are drawn out for use in retirement typically. One deduction when first contributed, one tax when withdrawn and kept out of the plan.
To summarize here and from the last article, debt of any kind is expensive and can make financial goals harder to achieve. However, keep in mind your options regarding the use of your money and credit. If nothing else, perhaps just knowing you have options will help with the pressure of making such decisions.
Securities offered through Triad Advisors, Member FINRA / SIPC. Advisory Services offered through Planning Solutions Group, LLC. Planning Solutions Group, LLC is not affiliated with Triad Advisors. PSG Clarity is a division of Planning Solutions Group, LLC.