savings

Take out TSP loan to buy a new car?

Don TaylorQuestionDear Dr. Don,
We have two Toyota Corollas (2001 and 2005 models) that we own outright. The 2001 is burning oil, but will survive a few more years as long as my husband is able to take the train to work. We have an emergency account that we just finished fully funding, two Section 529 college savings accounts, two Roth IRAs and my husband's TSP (Thrift Savings Plan) account, to which he contributes 5 percent of his pay.

I was wondering about the advisability of putting our extra cash (that is, no longer going into the emergency fund) into my husband's Thrift Savings Plan account (into the G Fund to be specific) instead of a bank account (money market, savings or CD) to save for a new car.

My thinking is that this will reduce our tax burden while we save, and the interest on a TSP loan would be lower than a loan from any bank or dealer. Furthermore, the interest (and principal) on the loan will be paid back into the TSP account, leaving our contributions overall higher than if we were to save in a savings-money market account.

I know it's not generally advisable to raid retirement funds for current-day purchases, but I've never seen the idea of using them to save for a big purchase with extra contributions specifically for that purchase. Any thoughts?
-- Shannon Strategizes

AnswerDear Shannon,
What's not to like? I think it's a great idea. You're pumping up the value of his retirement account, and you'll be repaying the account with interest over the Thrift Savings Plan, a defined contribution retirement savings plan for federal employees, loan term. I'm assuming the account balances will be high enough to allow you to borrow enough to buy the car when it's time.

I was once in the TSP when I worked as a debt management analyst for the Federal Home Loan Banks Office of Finance. I don't know the ins and outs of your investment portfolio, but I do know that the G Fund invests in Treasury securities. The G Fund rate at the time your loan application is processed is the interest rate you'll pay for the life of the loan. The G Fund interest rate was 2.5 percent at the time of writing this, but it may be higher by the time you're ready to borrow against your husband's TSP to buy a car.

One downside is that if your husband was separated from federal service, the loan would become immediately due and payable within 90 days. If not repaid, it would be considered a distribution out of the TSP account and would be subject to income taxation and, if he is under age 59½, potentially subject to the 10 percent penalty tax for early withdrawals.

The double taxation of loan payments is another possible concern. The Thrift Savings Plan Web page on loan basics explains this issue, excerpted below:

The interest you pay on your TSP loan is taxed:

  • When you pay the loan back with after-tax dollars.
  • When it is distributed to you as you begin withdrawing money from your TSP account.

That's the conventional wisdom. The unconventional wisdom, presented by Federal Reserve economists Geng Li and Paul A. Smith in a paper in 2009, puts a different spin on things by considering loan proceeds separate from loan payments. They hold that the loan proceeds are taxed by repaying the loan with after-tax dollars, and loan repayments are taxed when the funds are distributed in retirement. They do allow for the loan's interest expense to be taxed twice, but that is mitigated by the benefit of being able to defer this tax over the life of the loan. My advice is to let the tax arguments slide and start your savings program for your new car.

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