Bureaucratus

Borrowing from your TSP account

Feds participating in the Thrift Savings Plan (TSP) can borrow a portion of the money in their accounts for specified transactions such as buying a primary residence, paying education and medical expenses or meeting a financial hardship. Participants can only borrow from their own contributions and earnings.

I find it interesting that the interest rate charged on a TSP loan is the same rate now paid by the government bond fund (G Fund) when federal employees apply for the loan. Loan repayments by TSP participants are deducted from each paycheck and deposited back into their TSP account. Up front, it would appear that employees borrowing money from their TSP account at a rate of interest equal to the prevailing G Fund rate - and repaying that money into their own account - would wind up no worse off than if they hadn't borrowed at all. After all, they would replenish the principal they borrowed from their accounts. And the interest payments would be equal to the interest they would have earned if they had left their money in the account and invested it in the G Fund.

But the Thrift Investment Board says that's not always the case. In the board's new flyer explaining the amount that can be borrowed and the interest rate charged on TSP loans, it provides the following example as an illustration:

Assume that you took out a $10,000 mortgage loan from your bank at a rate of seven percent for 15 years. The monthly loan payment of principal and interest on such a loan would be about $90. Over the life of the loan, you would pay about $6,200 in interest to your bank.

Because mortgage interest is tax-deductible on federal income tax returns, the out-of-pocket interest expense for this hypothetical loan would be about $4,500 for someone in the 28 percent federal tax bracket.

That leaves $10,000 in your TCP account that you could have borrowed, but didn't. If you invested $6,000 of that in the G Fund and $4,000 in the C Fund, your TSP account would earn about $41,600 over the 15-year period during which you'd be repaying your $10,000 bank loan. At the end of the 15 years, your TSP account would have earned $37,100, after subtracting the $4,500 that your bank loan would cost.

These figures are based on the compound annual rates of return for G and C funds calculated by the Thrift Investment Board as the approximate historical rate of return for the past 10 years. The board estimated these rates at 8 and 15 percent for G and C funds respectively.

But what if you had decided to borrow $10,000 from your TSP account instead of from the bank? You wouldn't have had to pay $90 each month, but you'd have lost a portion of the $41,600 in earnings you otherwise would have received on your TSP account. In addition, the "interest" you pay yourself for a TSP loan used to buy a house is not tax-deductible because the loan isn't secured by your home. Catch 22!

The Thrift Investment Board provides a further illustration of this situation: If the TSP loan rate is 6 percent, you'll have to repay about $84 per month to your TSP account over 15 years. But using the same C and G fund annual rates of return as indicated above, you will have earned only about $27,500, according to the board.

Offsetting this diminished return somewhat is the $6 per month "savings" in your monthly payment amount - $90 a month to the bank vs. $84 to your TSP account. If you invested that amount at, for example, 5 percent over 15 years, you would earn about $1,500, the board said. That figure represents $1,100 in actual savings and $400 in interest income after federal taxes of 28 percent have been paid.

At the end of 15 years, your "net earnings" after borrowing from TSP account would total $29,000. The sum includes the $27,500 earned by your TSP account plus the $1,500 just enumerated. In this example, you have lost $8,100 in earnings after borrowing from your TSP account that you could have kept had you borrowed from a bank, according to the board. The board maintains that you're better off borrowing from a bank and letting your TSP account continue to grow.

I have no argument with their conclusion in this case, but I believe the example is misleading. In this scenario, the TSP loan costs more than the bank loan solely because the bank loan is secured by a mortgage, making interest payments tax-deductible.

I realize the Thrift Investment Board wants to encourage feds to save for their retirement, but I'm not quite sure I approve of using the above example to make that point. For starters, people who are seeking financing for a home purchase usually need a lot more than $10,000. If the bank won't lend you all the money you need to buy a home, and you're short $10,000, where else are you going to get the money? Borrowing from your TSP account makes perfect sense under such circumstances. In fact, your TSP account may be your only source for the money.

Why is the board trying to discourage such loans? If the interest on a TSP loan for a home purchase were tax-deductible, it would be the preferred way to finance a home purchase because the interest charged by the Thrift Investment Board is lower than the interest a bank charges.

I also object to their assumption that the $6 monthly difference can only be invested at a five percent rate of return. Where did they get that number from? Why don't they assume you'll put the $6 back into your TSP account? That sounds reasonable to me.

The board provides another illustration - this time to pay medical bills. It does not involve tax-deductible interest payments. And guess what? It shows that you're better off borrowing from the TSP than from the bank. No fooling. The board seems to have chosen a fairly long-winded way of warning you to consider tax consequences when deciding whether to borrow from your TSP account or elsewhere.

Perhaps the Thrift Investment Board should try to get the tax law changed so money borrowed from your TSP account for a home purchase becomes tax-deductible.

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Bureaucratus is a retired federal employee who is a regular contributor to Federal Computer Week and the author of Bureaucratus Moneyline, a personal finance newsletter for feds, available by subscription on Federal Computer Week's Web page at http://www.fcw.com. For more information, contact him at bureaucratus@fcw.com.

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