Using TSP to Pay Off Debt

“I have a tsp question for you concerning the new TSP withdraw options. I retired in 2015 from air traffic control at age 50. Will I be able to make a withdrawal? I would like to withdraw maybe $20000 to help pay some debt. If I can do that what is the tax rate and what will it do to my taxes at the end of the year? Thank you for any help you can give. I’m not sure who I can ask these questions. I’ve read the fact sheet but it doesn’t address this specifically.” – Susan

Paying Off Debt

Few subjects can keep a person awake at night like the insufferable feeling of being weighed down by debt. It rarely matters the amount, $10,000, $20,000, $50,000 in debt; it can all carry the same amount of stress.

Often the mind drifts to thinking ideas like,

“If I only had a big chunk of money that I would only need a one-time, I would never let this happen again.”

When you are trying to find a solution to getting out of debt, a financial windfall can feel like the only option to getting back on track, financially.

A financial windfall is when you take a large chunk of money and pay off debt. Those funds can come through various sources but are most often from an inheritance or even for some, using the Thrift Savings Plan (TSP) to pay off this debt.

The most frequent debt that we see our federal employee clients get into is credit card debt. Once you start carrying a balance on credit cards, the interest rate skyrockets. They can be as high as 18% to 29% in some cases. At these levels of interest rates, it can begin to feel that each payment you make only gets applied to the interest and not the actual principal of the debt.

Human beings are solution-oriented. We want to find the most immediate answer to solve our immediate problems. Here, Susan has a chunk of debt she would like paid off. Susan also has a “pile” of money that could eliminate the pain this debt causes her.

The most immediate answer is to just take the “pile”, in this case, retirement savings in the TSP, and pay off her debt. But is this the right answer for Susan?

What other consequences does Susan need to consider before she takes uses her TSP to pay off or down debt?

When we work with Federal Employees who have encountered this feeling of debt and are debating taking a withdrawal from their TSP to pay the debt down, we have to walk through the pros and cons.

Before we ever recommend taking money from the TSP to pay off debts, we need to first evaluate:

  • What are the consequences of accessing the monies before age 59 1/2?
  • What tax consequences do we need to prepare for?
  • What is the opportunity “cost” of taking money out of your TSP to pay off debt?
  • What “problem” did we solve?

Before September 15, 2019 – when the TSP Modernization Act passed, Federal Employees had limited options to access their TSP funds.

Now, with the passing of the Act, Federal Employees could use the TSP to pay down debt; but the real question is – should they?

TSP Modernization Act Withdrawal Options

The first question to answer is whether or not Susan, who retired from ATC in 2015 at age 50, can access the TSP to pay down her debt like she is wanting to?

Under the TSP Modernization Act employees have more access to make a partial withdrawal from their TSP’s.

Federal Employees can now take an Age-based withdrawal up to four times per the calendar year.

After you separated from federal service, there are no limits on the number of partial withdrawals you can take. Of course, there are still some limitations; like you can’t take more than one withdrawal each month.

You can also make partial withdrawals while you are in receipt of post-separation installment payments.

You’re not prohibited from making post-separation partial withdrawals.

The TSP is a retirement savings account sponsored by your employer, the Federal Government. Retirement savings accounts generally cannot be accessed penalty-free before you are age 59 1/2. However, there are exceptions once you separate from service if you do so before reaching age 59 1/2.

In Susan’s case, there are even more exceptions because you may remember that she was an Air Traffic Controller (ATC). ATC is considered to be a special provisions and their retirement is slightly different.

“Special Provision for Air Traffic Controllers, Firefighters, Law Enforcement Officers, Capitol Police, Supreme Court Police, or Nuclear Materials Couriers

  • 1.7% of your high-3 average salary multiplied by your years of service which do not exceed 20, plus
  • 1% of your high-3 average salary multiplied by your service exceeding 20 years” (opm.gov)

ATC employees, like Susan, are eligible to retire at at least age 50 with 20 or more years of service. Or, they can retire at any age with 25 or more years as an ATC. Most ATC Employees are subject to mandatory retirement at age 56 with very few exceptions.

To answer the first question we needed to evaluate for Susan, yes; technically she can access her TSP to pay down debt without penalities.

Now, what tax consequences do we need to consider?

Tax Consequences of Using the TSP to Pay Down Debt

One of the most overlooked aspects of retirement planning is tax planning. When you are in the thralls of your career earning taxes are always part of the financial planning process. But when people go to retire, they assume because their income is going to be less in retirement their taxes will be too.

What most employees who retire under FERS forget is that most of your retirement savings have been tax-deferred.

Meaning, when you enter retirement and start withdrawing or receiving money from these tax-deferred accounts, you will have to pay taxes. You will have to pay the worst kind that there are: ordinary income taxes!

When you use the TSP to pay down debt, you need to consider what account(s) you are going to pull money from and what tax status those accounts are in.

The only tax-free withdrawal options that you have from the TSP are:

  • Roth contributions (on which taxes have already been paid)
  • Qualified Roth earnings (paid tax-free when withdrawn)
  • Traditional tax-exempt contributions from combat zone pay

All other withdrawals are subject to ordinary income tax. Sometimes the Feds that we work with assume that because the TSP is an investment account that their withdrawals will be taxed at capital gains rates, generally lower for most people than ordinary income tax rates, but they are not.

If you have never withdrawn money from the TSP before keep in mind that the TSP office is REQUIRED to have 20% tax estimate withheld to send to the IRS.

In Susan’s case, if she wanted to withdraw $20,000 then the TSP office is going to send $4,000 (20%) to the IRS.

Meaning, Susan is going to receive $16,000.

But keep in mind that the $4,000 is an ESTIMATE. The TSP office does not know what income bracket that you are in. You could owe more on your withdraw or you could receive a refund.

Susan, for you to pay off your $20,000 of debt you are going to have to withdrawal $25,000.

$5,000 will be sent to the IRS as your estimated tax payment.

That’s substantially more of a withdrawal, Susan than you may have been considering.

To answer your question on tax consequences, the amount that you withdrawal will be considered ordinary income if it is coming from your traditional TSP. You will need to add this to the income that you have earned throughout the year to determine how much of the withdrawal is taxable.

Cost of Withdrawing Money from your TSP to Pay Off Debt

Opportunity Cost is something to consider before you take monies out of your TSP to pay off debt.

Opportunity cost is the loss of potential gain from one alternative when another alternative is chosen. If you take monies out of your TSP to pay down debt, those monies that had been invested are no longer able to potentially grow as part of your investment portfolio.

When will you need to make a withdrawal from your TSP: when the markets are up or when they are down?

You cannot time the markets but you can time when you choose to make a withdrawal.

You have to consider the long term impact on your retirement when you make one-time large withdrawals from retirement savings. Retirement accounts were designed to be a long term investment strategy to see you through the later stages of your life. Pre-mature withdrawals or deviating from your investment strategy will impact your retirement plan.

We strongly encourage you to visit with your financial planner before you make period withdrawals of this nature.

What problem did we solve by using the TSP to pay down debt?

When you make a one-time withdrawal from your TSP to pay down debt what spending problem did you solve?

You have paid down debt with a financial “windfall” and it feels really, really good. But that feeling of financial liberation is generally not sustainable.

You got instant relief but in our experience, that instantaneous relief did not fix a problem it offered a short term solution which will now become the default answer.

We have seen people swear over and over again that they will only use their TSP to pay off debt one time. Five years go by and they are in the same financial position as they were originally and the answer is once again to use the TSP to pay down debt.

Please, do not swear that this will not be you.

It can be you. The people that we work with are not “bad people” who cannot control aspects of their lives. Generally, they are highly educated, and otherwise, well-discplined people whose spending can just get a little out of hand from time to time.

Particularly, unmonitored spending and the accumulation of debt can occur when you enter retirement. This happens because FERS Employees spend the last 20+ years earning more, getting step increases, annual COLA and have watched their income continue to rise without ever considering one day it could plateau.

Paying interest hurts but when our credit cards are high and interest makes us sick: it’s probably a good time to realize we have to make some corrections because we are living beyond our means or have not been putting enough money into savings for “life events” that put us in precarious financial positions.

We are using credit card debt here, Susan, because it is the most common debt that we see but not always the correct analogy.

It is not always credit card debt, sometimes it is just debt because the car broke down, appliances went out, family members needed help. The list is extensive but the answer is always the same: we were not financially prepared enough to manage the situation.

Even after you retire, you still want to contribute to savings accounts because these little situations will and can occur.

With few exceptions, we rarely advise taking monies out of the TSP to pay down debt. The cost of doing so is generally greater than the benefit.

I am helping my clients to go through the retirement process without any problems. You might want to check out our 7 Retirement Mistakes so that you know what to avoid.

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