Unpaid TSP Loan at Retirement: What happens exactly?
For those of you in the “You’ll never recover financially from taking out a TSP loan” camp, you can probably just skip to the next article now. You won’t be happy here. And there’s no manager for you to speak to, Karen. And that statement isn’t always true anyway. If you took out a loan from your C Fund in the beginning of 2022, you’ve SAVED yourself money by not losing 20% of it in the market.
But, let’s just say that you did that. You took out a TSP loan recently. Now you’re fed up with the government and you want to retire. What happens to that loan that’s hanging out there, pending? Well, the rules have changed, so let’s explore it.
First, the old rules.
Prior to TSP’s “Summer of Inept Chaos ‘22” (not the official name, I don’t think), when an individual separated from the government, they had 90 days to pay the loan back, or it was considered a distribution. A distribution is just like taking money out, so they said that basically you had taken money out and that’s a taxable event. (You may even owe the 10% early withdrawal penalty, depending on your age).
So, when 90 days came, TSP zero’d out the loan (aka foreclosed), and made a note to send you a 1099 at the end of the year.
In the meantime, while the 90 day process was ticking along, you could not make a withdrawal from the TSP. They wanted to take care of the loan outstanding first. You could, however, notify the TSP and tell them you had no intention of paying the money back so don’t bother waiting 90 days. They would happily comply, close out your loan immediately, deem it a distribution and voila, your account is open for withdrawals.
New Rules are Different
When you leave the government now, you have a couple of options.
As with most things in life, “Do Nothing” is an option. TSP will, like before, eventually deem that you are not going to pay things back and will “foreclose” on the loan. You’ll get a 1099 at tax time for a distribution of the unpaid balance.
Repay the loan. This is a bit of a change from before. Old rules stated you have to pay it in full in 90 days. New procedures are a bit different. TSP will send you some correspondence. Federal law is silent on how many days the new deadline is. It simply says you have to repay it by the deadline TSP gives you. So what is TSP’s deadline? They appear to be silent in all of their literature on any hard and fast deadline.
However, having seen some of this paperwork from someone who had a loan, I can advise the following, having observed this with my own eyes: There will be 2 deadlines listed. One will be 60 days from notice of your separation. They will want the loan paid in full within those 60 days…OR….
You have another deadline: 120 days from date of separation, you will have to start making monthly payments. This is a big change. You can continue to make monthly payments on your TSP loan, even after you separate. You can use direct debit for this as well. Or send in personal checks. If you start making monthly payments and then stop, you’ll be deemed as foreclosed upon and the outstanding balance at that time will be considered a distribution.
If you do the math, this is obviously a strange wording. (Would you expect anything else from TSP???). You have 60 days to pay it off. But actually not really. Because you have 120 days just to start making the payments. So do you really have a 60-day deadline of any kind? Maybe TSP will formalize this a little more in the future.
Since the payments can now be continued into retirement, you are no longer prohibited from withdrawing or transferring money while a loan is outstanding. This is a big change as well. Section 1650.2(c) “An outstanding TSP loan will not affect a participant’s eligibility for a partial post-employment distribution or an in-service withdrawal.”
Here’s one for you tax nerds that like to know every loophole possible. Let’s say that you had a loan, you separated from the government, you didn’t pay it, and the TSP foreclosed. You now owe taxes on that unpaid balance since it’s considered income. You cannot repay a foreclosed loan. It’s history at that point. In the books.
But….
….what you can do is put money BACK into the TSP or even an IRA or another employer’s plan. You have to do this by the due date (including extensions) for filing your federal income tax return for the year of the loan foreclosure. Say what?!
Let’s walk through this:
Johnny has a $10k TSP loan outstanding and leaves the government on 10/31/22. He took the money out because he wanted to buy a brand new rifle for his upcoming retirement hobby of long range precision shooting. Johnny doesn’t have any intentions of paying this loan back. It’s his money after all. And, citing J.G. Wentworth’s philosophy, he can certainly decide what he wants to do with his own money. TSP gave Johnny a deadline of March 2023 to start monthly payments. Johnny threw that correspondence in the trash.
March 2023 comes and goes. TSP doesn’t hear from Johnny. They deem his loan a distribution. January of 2024 arrives. TSP cuts Johnny a 1099 for $10k. Johnny gets the 1099 and realizes that he’s going to owe taxes on that $10k. Johnny is in the 24% tax bracket so that means he’s going to have to pay $2,400 in taxes. Johnny doesn’t like this and calls his CPA buddy to help him out of a jam.
CPA buddy knows Johnny has won more than $10k in prize money in his shooting competitions. And that it’s still sitting in his bank account. So, before Hornady gets it, he advises Johnny to deposit $10k into an IRA before April 15, 2024. Johnny does that. Guess what Johnny owes in taxes for not paying off his loan? Nothing! What? He retired on 10/31/22, paid no tax on it in 2023, and now in 2024, he somehow gets out of paying taxes on it forever????