What is your highest value, financial asset right now? If you crunch the numbers, you’ll likely find that the balance of your Thrift Savings Plan (TSP) account ranks near the top of the list. In fact, for many federal employees their TSP’s value as an investment is only second to their home. With this in mind, consider the risks of taking a TSP loan.
The Hidden Tax Consequences
Consider this: you’re borrowing pre-tax dollars when you take a TSP loan then paying it back with after-tax earnings. This mean that, for every dollar you borrow, you have to earn that dollar plus your effective tax rate, in order to pay the loan back.
Add to this, you’ll be paying taxes twice once you start taking distributions in retirement. Why? Because, after paying back the TSP loan with post-tax earnings, you’ll be taxed again on those funds when this money is withdrawn.
“When you take out a TSP loan, your retirement nest egg suffers a loss of compound interest and grows at a slower rate.”
Loss Of Compound Interest On Your Loan Balance
Albert Einstein once said that compound interest is the eighth wonder of the world. Then again, Benjamin Franklin actually explained how it works when he said, “Money makes money. And the money that money makes, makes money.”
A TSP loan may seem attractive because the interest rate is based on G Fund earnings. As a result, the interest is usually lower than on a loan from commercial lenders. However, even though the loan interest is added back to your account as you make payments, it’s still less than the interest you could’ve earned by investing that money in a high-performing fund. When you take out a TSP loan, your retirement nest egg suffers a loss of compound interest and grows at a slower rate.
Paying Back The Loan May Cut Into TSP Contributions
Since TSP loan payments are automatically deducted from your pay, you may not be able to increase contributions to your TSP account. Depending on when you plan to retire, this is yet another way a TSP loan can cut into your nest egg. In fact, if you’re closing in on retirement with a significant balance due on your TSP loan, the risks are even higher.
The TSP was never intended to be used in the same way as a traditional savings account for things like paying for a wedding or starting a small business. Think of your TSP as your last source of money for an emergency when there are no other options like taking out a home equity loan or refinancing your mortgage.
