Before you do any strategy with your TSP make sure you understand the long-term ramifications. Image: Watchara Ritjan/Shutterstock.com
People love not having a mortgage in retirement.
It simply feels great to own your home free and clear.
And no mortgage payment makes it easier to be able to afford to retire in the first place.
But if your home isn’t paid off by retirement, is it worth tapping your TSP to pay it off in one fell swoop?
Be Careful!
Not having a mortgage is great but taking a large TSP withdrawal to make it happen is often a bad idea.
And sometimes it is a really bad idea.
The two main reasons for this are taxes and opportunity cost.
Taxes
Most federal employees have the majority of their TSP savings in the traditional side of the TSP and not the Roth. This means that when you put the money in, you didn’t have to pay taxes on that money, but you do when you take it out.
Note: For the Roth TSP, any qualified distribution will come out completely tax free.
And Traditional TSP withdrawals are not taxed at favorable capital gains tax rates. They are taxed at your higher ordinary income tax rate.
In short, your Traditional TSP withdrawals will simply be added on top of your other taxable income like your pension, social security, etc.
Also, you have to know that for most types of withdrawals the TSP is required to withhold 20% for taxes. So if you request $10,000 then they’ll send you $8,000 and $2,000 to the IRS.
So if you want to end up with $10,000 net then you’ll have to withdraw $12,500 gross.
Note: Just because the TSP withholds 20% that doesn’t mean that that is exactly the amount of taxes you’ll owe. That will depend on your tax bracket.
Paying Off House: Example
Let’s do a quick example to see how this might work.
Let’s say there is a couple who brings home about 100k/year in retirement. They owe $250,000 on their house and they decide that they want to be completely debt free and pay off their mortgage with their TSP.
They request a withdrawal of $250,000, but the TSP only sends them $200,000 with the remaining $50,000 (20%) going to the IRS.
Now that they know about the 20% withholding, they request an additional $62,500 so that they get $50,000 after the withholding.
After the dust settled, the total they withdrew from the TSP was $312,500 which is a big bill just to get rid of a monthly mortgage payment of $1,500-$1,800.
But we are not out of the woods yet. That $312,500 would then be added to their other income of 100,000 for a total of $412,500.
Keeping the tax calculations simple, let’s assume that the only deduction they have is the standard deduction for a couple, which is $29,200 in 2024. Their taxable income would be $383,300 ($412,500 minus the $29,200 deduction).
Before withdrawing the money from the TSP, with an income of only 100k, they were in the 12% tax bracket. Now they are slammed up into nearly the 32% marginal tax bracket with an effective tax rate of around 20%. That means they would have to pay almost $75,000 in income taxes this year!
Opportunity Cost: Kick You While Your Down
Now if the numbers already didn’t look bad enough, the opportunity cost of the money taken out of the TSP is sure to be the final straw.
If this couple kept the $312,500 in their TSP and invested it 100% in the G fund for 15 years, assuming an annual return of 2.23% (the 10-year average for the G fund), that $312,500 would have turned into $435,036.24 (growth of $122,536.24)
Now imagine if they had invested a portion of that money in some of the other funds which, historically, have earned much more than 2.23%. The difference becomes unignorable.
Better Way
If after all of this you’d still like to pay off your mortgage with the TSP then one way to do it is to spread out the TSP withdrawals over a number of tax years.
So instead of taking one massive TSP withdrawal you take out 5 smaller ones over 5 tax years.
This often limits the tax impact and keeps you in lower tax brackets while also paying off your mortgage early.
Final Word
Before you do any strategy with your TSP make sure you understand the long-term ramifications.
Everyone’s situation is different, but it is your responsibility to know what this type of decision means for you and your family.
Dallen Haws is a Financial Advisor who is dedicated to helping federal employees live their best life and plan an incredible retirement. He hosts a podcast and YouTube channel all about federal benefits and retirement. You can learn more about him at Haws Federal Advisors.
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