Thread: TSP as a tax free vehicle to save for a down payment on a house?

Welcome tsp07! I'll let some of the experts here pick apart the pros and cons of this scenario but I'll play devil's advocate for a minute and give a what it.

During a 3 year period, it would be difficult to anticipate earnings. Just like someone 3 years from retirement, if you need the money soon, you really want to be conservative rather than aggressive. That is unless you are willing to take the chance and risk actually losing money. So, what if the market goes down in the next 3 years? Can you live with that?

Good luck in whatever you decide.
Tom

TSP07,

I agree with tsptalk you are looking at a loan repayment that can affect your retirement funds.

We have a senior member/moderator in Guam that knows a lot about realestate and TSP. His login is pyriel. Send him a personal message (PM) and the two of you can chat about the pros and cons.

I had borrowed $$$ to purchase property a few years back. My advisor said (I don't necessarily agree) that that was a bad idea. He said you end up paying taxes twice; once as you pay the loan back, and then again after you retire and withdraw those funds again. Food for thought.

I agree with Brett. By borrowing from your TSP to avoid taxes on the savings, you end up getting taxed twice (repayment monies are taxed, taxed again after you retire.) instead of once---which was what you were trying to avoid. Not to mention the lost growth in the account...

I wouldnt do it on the basis of tax avoidance.

Thank you all for your comments! A few points and questions:

I called the TSP office and they assured me that repayments of the loan and interest are paid with pre-tax dollars, so you're not taxed on it.

Tom and others -- paralleling the risk/reward ratio of the last few years of retirement with saving for a downpayment for a house for a few years is a point very well taken and one that I hadn't considered -- thank you!

What appeals most to me about the idea of borrowing against myself is that the money would go in with pre-tax dollars -- $15,000 of pre-tax money is like putting in $22,000 of post-tax dollars (depending on tax-brackets, etc).

Also, I can understand what you're all saying about not messing around with my retirement money. However, please understand that the $15,000 that I'm talking about putting away each year is solely for a downpayment on a house, whether I put it in the TSP or not -- it's not money that I would put toward retirement.

The conundrum for me is that while using the TSP as an investment vehicle for saving for a house down payment would enable me to save for it with tax free dollars and avoid capital gains (until I retire) I'd end up having to pay myself about $400 a month for 15 years, albeit to myself, that would just be one more monthly payment while the purpose of putting down a downpayment is to lower your monthly payments.

I'm starting to think this may not be the best idea.

Am I crazy, sane, or somewhere in between?

Originally Posted by tsp07

I called the TSP office and they assured me that repayments of the loan and interest are paid with pre-tax dollars, so you're not taxed on it.

I'm not sure who you talked to, but they lied. Check your LES statement. The only thing under "non-taxable" wages is your health premiums. The only thing under "tax-defferred" wages is your TSP contributions. Loan repayments are taken from taxable wages.

Check the sentence in red.




Electronic Processing of Participant Loans in Retirement Plans

By Howard M. Phillips
PDF version
SOME CALL THEM LOANS; others refer to them as tax-free distributions. Whatever you call them, most salary savings retirement plans offer them to participants who are in need of pre-retirement funds. According to a September 2003 Employee Benefit Research Institute issue brief, based on 2002 data, 84 percent of 401(k) participants are in plans that offer loans. Only 51 percent of all plans, however, have a loan provision. Ninety-two percent of plans with more than 5,000 participants have loan provisions, and this grades down to 82 percent for plans of between 501 and 5,000 participants; 75 percent, 251 to 500; 66 percent, 101 to 250; 60 percent, 51 to 100; 54 percent, 26 to 50; 44 percent, 11 to 25; and 35 percent, one to 10.
Because the main focus of a retirement plan is having an accumulation at retirement to sustain home and family, IRS rules and regulations with respect to participant loans are strictly enforced. These rules and regulations stipulate to the maximum loan and the maximum period over which it may be repaid.
Retirement plan participants like the idea of accessible cash when they need it. Participants also enjoy the lower cost of borrowing from their own retirement funds. A government study has concluded that there is more than a one third increase in retirement savings when a salary savings retirement plan provides for loans. A Government Accountability Office study of loan provisions and 401(k) plans, GAO/HEHS 985 401(k) Pension Plans, presents analysis indicating that the average annual contribution amounts are 35 percent higher in 401(k) plans with loan provisions compared with 401(k) plans without.
The current loan system is not without flaws. Loan processing can take three days to three weeks, which can be a real hardship for borrowers faced with an emergency. Plan sponsors dislike the paperwork and administrative burden of processing loans and the unpleasant task of chasing after loan payment defaults.
When a participant terminates employment, most plans require full repayment of the loan. A participant who cannot repay the loan is deemed to have received the loan amount as a distribution, subject to tax (and a possible penalty) in that year.
But the availability of participant loans does have positive value for participants. Contribution amounts increase, and participation rates increase, because participants take comfort in knowing that pre-retirement access via a tax-free distribution from their account is available, should there be a need to retrieve some of the retirement savings. This positive value applies especially to plans with fewer than 500 participants, because there is a significant amount of room for improvement in plan participation in plans of this size.
Consolidation of high-interest debt is accomplished with a loan, where the interest cost is paid to the participant’s retirement savings account. Such a consolidation would fit into one of the plan’s reasons for a loan (should the plan require a reason).
Leakage from retirement savings occurs when a participant terminating employment must repay an outstanding loan or pay tax on the unpaid debt. Many participants not only lose that part of their retirement account previously taken as a loan they also have to borrow from high-interest cost sources to pay the tax. Leakage is extinguished by loan administration systems that allow for post-employment repayment to the retirement savings account. According to the 401(k) Handbook, Employee Benefits Series, Vol. 14, No. 1, Dec. 2004, “Outsourcing loan administration would make it easy for plans to eliminate the immediate repayment requirement.”
Those who do borrow from retirement accounts typically have a good deal of that account invested in low-yielding money market accounts. Investing one’s account in a loan to oneself may increase the yield on that part of the account to the prime rate (or prime plus one). The interest rate charged for participant loans must be commensurate with the prevailing rate charged by a person who is in the business of lending money for a comparable loan.
In practice, it’s very common, if not universal, for the plan’s loan interest rate to be stated as the prime rate on a given date. Since the prime rate is generally a lending measurement by financial institutions, and since most participant loans are secured loans with identical security (the participant’s vested interest), the prime rate for participant loans has been an accepted interest rate applicable to participant loans.
Some would argue that borrowing from a tax-favored retirement savings account is a poor decision. Participants tend to stop making contributions to the plan while the loan is in effect.

Participant loans are processed and administered manually, through privately created software or payroll deduction systems. A better resource to process and administer these loans would be a bank card processing company. Such a company can provide:

• monthly billing statements;
• 24/7 access to loan information via Internet or telephone;
• summary loan information on participant quarterly statements through a link with the plan vendor (as if loans were an investment option);
• loan repayment collections by an automated clearinghouse, Internet, telephone, or check;
• flexibility in repayment amounts above the IRS-mandated minimum repayment schedule;
• handling repayments after termination of employment.

If a retirement plan participant wants to accomplish a stated financial transaction, he or she can access cash reserves, a home equity loan, a margin securities account loan, a credit card, or a retirement plan loan for the funds.
Most participants, especially those who don’t have access to a home equity loan or margin securities account loan, fulfill their borrowing needs with a credit card, paying high interest. Consolidating such debt through a retirement plan loan significantly reduces the cost of borrowing.
Some would argue that borrowing from a tax-favored retirement savings account is a poor decision. Participants tend to stop making contributions to the plan while the loan is in effect. They pay back the loan with after-tax dollars and are therefore taxed twice (because the distribution later is taxed). And the participants lose investment return.
On the other hand, participants paying back high-cost credit card debt may transfer that debt to a participant loan and free up a portion of the debt service to inflate retirement savings, because the borrowing costs on the participant loan are significantly less than the credit card debt.
Loan proceeds that are repaid are later distributed from a qualified retirement plan and are taxed once. The loan is a tax-free transfer, and repaying the loan principal, ignoring investment growth, puts the retirement account in the same position it would have been had there been no loan. If we trace the cash flow, we find that the financial transaction accommodated by the loan is fulfilled with pre-tax dollars. When some future after-tax money is used to pay back the loan principal and ultimately is taxed again, the net result of all the flow from the plan is a single tax on the amount of the loan principal in the distribution. When the plan account is distributed, the participant receives a double-taxed distribution but already owns a never-to-be-taxed financial transaction, the net of which is a single tax.
It can be demonstrated that many loans taken by participants reside in a plan money market account. The likelihood is that the payback interest rate from the participant to his own account after it’s borrowed may be higher than the money market rate the money earned before it was detoured into the loan. Therefore, there may be no loss of investment return; there may even be a gain.
Participant loans are here to stay. Our focus should be on establishing loan systems that have positive value for participants, plan sponsors, and third-party administrators.
HOWARD M. PHILLIPS is a consulting actuary in Fairfield, N.J.

Thanks for the article mlkman! I am thoroughly confused now as I have called the TSP office twice now and they have assured me that loan repayments are made with pre-tax dollars.

All I can tell you is that when I paid back a TSP loan a few years back, it was with after tax dollars.

Another word of note if you take a loan, wait until the market is in a sustain bear market. Think of how much money one might have actually saved in 2000 thru 2002 if they had taken out a loan during that time. Of course knowing when it's coming is the big stinker...............

i have a loan now and they are taken taxes now, so much for tax free i thought it was not taxed but your right M M on pay stub they are taxing me

Originally Posted by mlk_man

All I can tell you is that when I paid back a TSP loan a few years back, it was with after tax dollars.

Another word of note if you take a loan, wait until the market is in a sustain bear market. Think of how much money one might have actually saved in 2000 thru 2002 if they had taken out a loan during that time. Of course knowing when it's coming is the big stinker...............

That would be one of the times that I would take out a TSP loan... Get double utility from your money instead of just parking it in G.