by Chris Kowalik of ProFeds
Recently, the Thrift Savings Plan (TSP) issued new guidance with respect to the withdrawals and the loan options for participants affected by COVID-19 and how it will make TSP monies available under these special rules that were spawned from the CARES Act that passed earlier this year. The CARES Act allows for enhanced access to various types of funds, including the TSP, for those participants affected by COVID-19.
I recently published a podcast about these new withdrawal rules under the CARES Act, which you can listen to HERE.
But before you take any action, there are some potential problems and maybe points of consideration that I hope you’ll really think through before deciding to move forward.
Is taking money out of the TSP under these rules advantageous for you? Or are there some hang-ups that you hadn’t considered? What are some concerns if you take the withdrawal or loan options?
Concern #1: Taxes
There is favorable tax treatment with respect to the CARES Act that almost entices people to take this money, which I want to draw a little bit of concern to. The amount that you withdraw from the TSP under this provision can be claimed over the next three tax years, so you’re essentially spreading out the claiming of that money as income. Your traditional money that comes out of the TSP is going to be taxable to you. So, your question to yourself would be, do I want all of it to be taxed in one single tax year? Or is it more advantageous, which it likely is, to spread it out over the next three years?
When this money is paid to you and it’s taken out of the TSP, there will not be the typical mandatory 20% withholding. Normally for any kind of distribution or withdrawal that comes out of TSP, there is a 20% mandatory withholding on it, because eventually you’re going to have to file your taxes for that year and you’re going to owe tax on the vast majority of that money. (If you have some money in a Roth account, you won’t owe tax on that, but for all the traditional money, that is all going to be taxable to you.) In these special rules under the CARES Act, they will not issue a 20% mandatory tax withholding, but you can ask for one.
A little word of caution here is that if you do not anticipate paying the money back, don’t put yourself in a bind by not withholding anything from this money being paid to you, and then come tax time, have a really difficult time wrestling with that tax obligation. Don’t put yourself in a bigger bind than perhaps you already are by taking out this much money from the TSP.
Another tax concern is that you will need to be ready for more complicated tax filings. If you take this money out of these special provisions under the CARES Act and want this favorable tax treatment, you will have to be prepared for a more complicated situation come tax time. If you already work with a CPA, they’ll be able to figure all that out, but if you’re used to doing your own taxes, that might get a little bit complicated.
Concern #2: Eroding Your Savings
When deciding to take money out of the TSP, you want to make sure that you are using this option as a very last resort. The reason is that when you take this amount of money from the TSP, you are spending that money and you can’t get it back. If you’re considering paying off your house or doing something else like that, you no longer have access to that money in retirement. So you want to be very careful. I like the old adage, “just because you can do something doesn’t mean you should.” You should think very carefully about taking this amount of money from a retirement account.
What you don’t want to happen is that through this, for your access to the TSP money, that you end up eroding the long-term savings vehicle that you’re trying to build and preserve for retirement. You’re going to need that money, and if you use it too loosely now, then it may have a greater impact on your ability to make that money last as long as you do in retirement.
Concern #3: Locking in Losses
The last concern that I’ll mention is this idea of locking in losses. Many of you have heard of what we in the financial services industry refer to as the “Retirement Red Zone.” It is the five years immediately prior to retirement, and it’s your first five years of retirement. This is a time that you, as an investor, must be incredibly careful. The reason being is that you do not have the opportunity to wait for a market to recover. You likely need that money to be in place ready for withdrawal and hopefully have a strategy, not just taking the money out willy-nilly, but that you have a strategy on how to withdraw the money and do it in an efficient way.
If you fall in that Retirement Red Zone, you want to be very careful before you take a large chunk out of your TSP—especially when the market is down and you’ve locked in a loss, resulting in a lower account value to be able to pull from over the remainder of your lifetime. If your account has recently suffered a hit, if you’re in the C, S and I Funds and your account has not recovered, taking either the withdrawal or the loan option is going to lock in your loss. It’s not just a loss on paper anymore. It’s a real loss because you have sold those shares.
We know that we’re supposed to buy low and sell high. We know that’s the rule that we’re supposed to follow. But in this case, if you take a withdrawal or a loan, or frankly transfer your account let’s say from the C Fund over to the G Fund, you are effectively locking in your loss today. If you decide to pay that money back, let’s say you take a withdrawal and over the next three years, you’re going to go ahead and pay that money back, you very well might be buying back at higher share values. In fact, I hope you do because that’s indicative that the market has recovered and we’re back up to nice high share prices, so keep that in mind.
These recent market conditions have exposed a weakness in the Thrift Savings Plan. At the end of 2019, the TSP enacted the new withdrawal rules under the TSP Modernization Act, and it gave you much freer access to be able to get to your money in retirement. However, the TSP did not fix a critical part of their withdrawal options—and that is they do not allow participants to pick and choose which funds to pull from.
Let me give you an example. Let’s say you have half of your money in the G Fund and half of your money in the C Fund. The money that’s in the G Fund has not suffered a loss at this point—that G Fund doesn’t suffer losses. It only has gains, which is great. You also don’t get those big gains over in the G Fund, so there’s some downside there, but it’s maybe not as obvious. The C Fund, of course, is where you can get massive gains and massive losses; it just depends on what the market conditions are. If we’re in a situation where the market is doing really well, and we had a choice of whether we wanted to take money from the G Fund or the C Fund, we would prefer to take it from the C Fund. The reason being that the value of those shares is high because it’s performing very well. Buy low, sell high.
If we had a choice, that’s what we would want to do; however, the TSP doesn’t allow you to choose for the withdrawal that you’re going to take this month, or the lump sum withdrawal that you’re going to receive. Conversely, they don’t allow you to do it the other way either. If the market is down like it is now, and it has been for a couple of months, you don’t have the choice to leave your C Fund alone because you don’t want to sell low and just take your money out of the G Fund. It doesn’t work that way. The TSP does not allow participants to pick and choose which fund to pull from.
When you’re taking money from the TSP in undesirable market conditions, if you have any of your money in the C, S and I Funds, when you take money out, you are locking in the loss that you have already had, but haven’t felt yet. Because again, you haven’t sold the shares yet. But once you do by taking this withdrawal option or the loan option, you have now locked in the loss. So again—something that I really want to stress to everyone—just because you can do this doesn’t mean you should.
Too good to be true?
If you meet the basic requirements to take these options, and you think maybe this would be a great time to access that TSP money and pay off debt or pay off the mortgage, or whatever idea you have where you’re actually spending the money—this is a big concern, a really big concern. You don’t want to deplete your assets that are designed to be there for the remainder of your lifetime.
More details are expected to come from the TSP in the coming weeks, but I wanted to offer some thoughts sooner than later about what the real impact can be on your retirement savings by taking one of these options.
I hope you’ll factor in all of these considerations and concerns before making any decisions regarding your TSP, because sometimes these options look too good to be true. And if we don’t always understand the financial impact of what we’re doing, we can make bad decisions without realizing it.
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Chris Kowalik is a federal retirement expert and frequent speaker to federal employee groups nationwide. In her highly-acclaimed Federal Retirement Impact Workshops, she empowers employees to make confident decisions as they plan for the days when they no longer have to work.
As the developer of dozens of highly-regarded retirement planning materials for federal employees and the creator of the FedImpact Podcast, Chris has also analyzed the challenging retirement scenarios for thousands of federal employees – helping them to avoid costly mistakes, and highlighting opportunities for them to gain greater financial security in their retirement years.
Chris’ candid and straightforward nature allows employees to get the answers they need, and to understand the impact these decisions have on their retirement. After all, if what you thought was true wasn’t, when would you like to know?