Happy Patriots’ Day! Yes, it’s mostly a Boston holiday, but everyone in the United States could find a reason to celebrate it. I love 11AM baseball (but not as much as I loved 8AM baseball when I lived on the West Coast).
I was very excited to get this blog post out this morning, but I had a disappointing experience at my son’s school. It turns out that I had unknowingly been breaking a school rule for about 6 months. They explained the rule to me this morning. I explained how we were in compliance with the rule. They then clarified an unwritten, not-communicated point about the rule. That point makes a lot of sense for the whole existence of the rule know that it is clarified. However, I defend my wife and myself taking it literally.
The end result is that we felt terrible that we were taking advantage for 6 months. They probably felt terrible that both me and my 4-year old were confused. Hurt feelings all around. The lesson as always: Communication is important.
You aren’t here for communication lessons, so let’s move from personal to personal finance, shall we?
In the past 10 years I’ve read a lot of personal finance articles. There are almost no absolutes in personal finance. However, this comes close: “Never borrow from your retirement plan.”
Case in point. From Here’s what happens when you take out a loan on your 401(k):
[I bolded the point about double taxation, because I’ll cover that later.]
“While 401k borrowers are borrowing from themselves, this isn’t a harmless transfer of money from one pocket to another, experts say. ‘The best spin you could put on it is it’s the lesser of several evils,’ said Greg McBride, chief financial analyst for Bankrate.com.”
Borrowing from a 401k plan exacts a big opportunity cost. Borrowers miss out on any compound growth that their investments would otherwise have earned in the market.
Unless the money is repaid quickly, the loan represents a permanent setback to retirement planning, McBride said.
Those who borrow from their 401ks lose out on tax efficiency, too. Loans are repaid with after-tax dollars. In other words, someone in the 25% tax bracket would need to earn $125 to repay $100 of the loan. Savers’ 401k money is taxed again when withdrawn in retirement, so those who take out a loan are subjecting themselves to double taxation.
Employees who leave their jobs, are laid off or fired typically have to repay their loan within 60 days. If they don’t, the loan amount is considered a distribution, subjected to income tax and a 10% penalty if the borrower is under 59 and a half.
[CFP Andy] Smith’s list of acceptable reasons to take a 401k loan is short: to pay back taxes or other money owed to the IRS, to pay a tax lien, or to try to avoid bankruptcy.
But to the extent possible, experts say it’s best to avoid getting into a situation where we need fast cash in the first place. That means setting aside a liquid emergency fund of six months’ expenses.
Whew! That was a lot of digest. I’m not going to into each point. Instead, I’ll use that as a “flavor” of the issues… and then drill into a few points that I consider significant in our situation.
Today, I want to challenge the thinking about borrowing from a retirement account. Or at least, I want to make a case that like almost everything in personal finance… it is personal.
Regular readers know my wife is an officer with military benefits. As a government employee, her retirement program isn’t a 401k, but a TSP. As best I can tell there aren’t any significant differences between them… other than TSPs tend to have investment choices with extremely low expenses. As best I can tell a TSP loan is almost the same as a 401k loan. TSP loans aren’t written about very often because they aren’t as common.
If you aren’t familiar with TSPs, it might be best that you think “401k” when you read “TSP.” As always, please consult your professional financial and tax advisor about any and all of this stuff.
What are TSP Loan Terms?
Because TSPs are a government plan, taking a loan out is straight-forward. There’s no need to talk to a loan officer and justify your need. The theory seems to be, “It’s your money, you can get it easily… under these conditions.”
There’s one set of conditions for buying a primary residence, but that’s not us. The other set of conditions are the ones we are interested in. I’ll focus on those.
It seems you can currently take a loan of up to $50,000 at 2.375% for up to 5 years. It’s a fixed rate. Procedurally, it is as simple as sending in the application. You pay it back with the interest into your own account. Yes, instead of paying interest to the bank, you are the bank. You are lending it to yourself.
There’s a fee involved… a one-time, $50 processing fee.
You might think there’s some kind of breakage issue involved. There might be with 401Ks, but TSP loans can be set up to come out of your paycheck. You set it up once and forget it.
Defending a TSP Loan
My wife has been maxing out her TSP contributions for around 15 years. That’s roughly $16,000 (some years were less and now it’s more) a year or around $240,000. The stock market has been doing well, so there are investment gains as well. It’s not a small account.
Let’s address a few points:
- Undermining Our Retirement Plan
While the TSP account isn’t small it also ISN’T the major focus of our retirement plan. I don’t think taking a TSP loan undermines our retirement planning at all. I understand how it would most people, but we aren’t most people.
- Opportunity Cost
This may be considered one-in-the-same as the above point. However, I wanted to make a special point that the stock market has had an extreme run over around 8 years now. In the short term, I think the opportunities aren’t that great. That’s because I know where the stock market will go now (I write half-jokingly.)
If the stock market stays relatively flat for a few years as I think it might, the loss of opportunity is minimal. I don’t want to discount it completely, but I no longer assume that we’ll get 7% over the next 3-4 years.
I might falling into the same trap that Punch Debt in the Face did in 2013. I hope not.
- Loss of Job
This is the bogeyman that keeps financial planners up at night. It’s a trifecta of financial pain. You need to come up with a pile of cash in a short time. You have no job. You presumably have no emergency fund (or you wouldn’t be borrowing in the first place.) You are going to have pay income tax on the money and a 10% penalty. Penalties and fees always make me feel ouchies (to borrow a phrase from our kids).
With my wife’s career, the likelihood of job loss is minimal. High ranking officers aren’t typically fired. Also a pharmacist can usually get work relatively quickly (even if it is an hourly wage.) We have some other coverage even in this extreme case… such as these hidden emergency funds.
Why Should We Get a TSP Loan?
Maybe I should have addressed this above. I wanted to dispel the general reasons why experts are against retirement loans before getting into “Our Why.”
Last week, I wrote about our surprise condo assessments. They are around $20,000 for each condo unit… and we have two in the property. The terms of the loan are 5.2% for 11.5 years and then they adjust to some higher rate.
We could try to sell the properties, but that seems to be a terrible idea. When you considering these expenses would be passed onto a prospective buyer they will offer $20K less than the value of the properties a few months ago. After seller fees, it would amount to a fire sale… a big loss to us. However, the rents are good and the financing would lead us to lose an extra $100 or so a month. That’s not a huge amount. We still have a tremendous price-to-rent ratio (it was around 6.5, but now it’s probably closer to 8).
While the one-time $20K seems like a lot (and it is), each of these properties should earn us $10K a year when they are paid off. Perhaps they will earn even more as the property is greatly upgraded.
The terms of the loan that the condo association got really caught my attention. As I was I writing the article, I realized how terrible the terms are for people with great credit like us. It isn’t competitive with current fixed loan rates now and it feels like an exploding loan as it will adjust in some unspecified way in 11.5 years. I defer to Clubber Lang for a prediction on how these loan terms will turn out for most owners:
I’d rather have a loan at a fixed 2.375% rate vs. an exploding 5.2% rate. Wouldn’t you?
There are a couple of other reasons why we might take this loan.
- Paying Off Our Solar Panels
We financed solar panels a couple of years ago with a HELOC. It had a good teaser rate at around 2.5%, but it is 4.5% now. If I had it to do over, I would have locked in a TSP loan at around 1.5% back then and use that. I simply didn’t realize we had access to better rates.
I don’t miss paying for electricity. And I think I’ll enjoy each and every year of the next 25 years of not paying for it (or paying pennies for it).
- A Master’s Degree for My (Pharmacist) Wife
I never would have thought of looking at a TSP loan unless my wife mentioned that her friend is doing it to finance a master’s degree. It seems that is the next step in the corporate/military ladder. Borrowing for an advanced degree might make sense for most people, but for a doctor (of pharmacy) it seems like a step back to me.
I shrug my shoulders and justify it as complimentary. It might make her a Captain. It might not. It can only help, right? And if it doesn’t carry weight with the government, it will carry weight in the private sector.
Retirement Loans and Double Taxation
Remember the bolded text above about double taxation? Clearly Marketwatch couldn’t be wrong about double taxation of 401K loans, right?
Vanguard makes the great point that “First, it’s easy to see you aren’t ‘taxed twice’ on the principal balance of a ‘k’ loan. If you borrow $10,000 from your retirement plan, you receive $10,000 to use as you want — you don’t have to pay taxes on it.”
This makes sense to me. You weren’t taxed in withdrawing the funds the first time, right? You simply have to put in what you took out.
The analysis on the interest is more complicated. I defer the Vanguard article. Worst case scenario we’d be taxed twice on that interest. However, the amount of interest we’d be charged is fairly minimal. One calculator projected it at around $200. If the government wants to tax me twice on $200 interest, I say Bravo Zulu.
It seems to me that there are legitimate reasons to take a loan from a retirement account… and I don’t think they need to be “last resort” reasons.
There is at least one important question that I didn’t answer above. Why not have an emergency fund to cover this?
We have layers of emergency funds as I hope I explained. The extreme expenses from the condos are somewhat planned for. We could finance them, but I think we’ll decide that we have better options.
The alternative is to not invest a sizable amount of money… and I’m not sure that is a great idea. In all the retirement articles I’ve read, I didn’t find something like “put the money under your mattress.”