As federal employees near retirement, many questions inevitably come up. One common question I am asked is, “should I use my TSP to pay off my mortgage?” And my answer almost always is, it depends. Though it might seem like a smart financial move, several factors should be considered before deciding to pay off your mortgage. These factors range from the non-financial, such as how you feel about debt, to the financial, such as which option will increase your wealth the most.
And while everyone’s situation is different, there are some significant financial disadvantages to paying off your mortgage with your Thrift Savings Plan. So, before you cash that TSP check, continue reading to learn about the two primary disadvantages of using your TSP to pay off your mortgage.
Tax Implications
The first and often the most significant disadvantage of using your TSP to pay off your mortgage is the tax implication. Since federal employees often have most of their money in their traditional TSP, which is pre-tax, meaning no taxes were paid on the money put into the account, all withdrawals are subject to taxation.
But wait! Taxes are due not only on the pre-tax contributions but also on the investment growth. So, the total distribution from your traditional TSP will be fully taxable at ordinary tax rates. (Not capital gains rates!)
We have a progressive tax system, meaning the more money you earn, the higher the tax rate you pay. And since distributions from your traditional TSP are treated as taxable income, when you withdraw money from your TSP, it can push you into a higher tax bracket.
Now let’s look at an example of how withdrawing a large amount from your traditional TSP could trigger a huge tax bill:
So, for our example, let’s say you want to pay off a mortgage of $250,000 and have the following income:
Now, if you were to take a $250,000 withdrawal from your TSP to pay off your mortgage, your taxable income would increase by the amount withdrawn.
However, since the TSP is required to withhold 20% of all distributions for estimated taxes, your withdrawal would have to be even larger.
This means if you need $250,000 to pay off your mortgage, you will have to withdraw $312,500 ($250,000/.80). Therefore, you will take $250,000, and the TSP will send $62,500 to the IRS.
But remember that the 20% withheld is only an estimate.
In our example, your tax liability would be closer to the following:
So, your federal tax bill for the year would actually be closer to $109,200, and this isn’t including any state tax you might be subject to.
In this example, you went from paying approx $23,400 in taxes to $109,200. But hold on, how will you pay this tax bill? Well, you would likely have to increase your TSP withdrawal to include the taxes. Meaning if you want to pay off a mortgage of $250,000, you will have to withdraw approximately $359,200 ($250,000 for the mortgage and $109,200 in taxes).
Clearly, taxes are an essential consideration when deciding whether paying off your mortgage is the right financial choice. And overlooking the tax consequences of using your TSP to pay off your mortgage can be a critical mistake.
Note: Unlike the Traditional TSP, with the Roth TSP, you pay taxes upfront, and once in your Roth, your contributions grow tax-sheltered, and as long as you meet specific IRS requirements, your withdrawals are tax-free during retirement.
Opportunity Cost
When thinking about living debt-free, it can be helpful to categorize debt as good debt and bad debt. Your mortgage will likely fall into the good debt category because mortgage interest rates are historically low.
Since interest rates are so low, it means the opportunity cost of taking money out of your TSP will be even greater. So, if the interest paid on your mortgage is lower than the rate of return of the investments in your TSP, you’d be better off by keeping your money in the TSP.
For instance, if we continue with the numbers used above, and you kept the $359,200 in your TSP for ten years and received an average rate of return of 8 percent a year, your $359,200 would have grown to over $775,485! That’s an additional $416,285!
Now compare that to the money you would have saved if you paid off a 30-year fixed mortgage with ten years remaining and an interest rate of 4 percent. Paying off your mortgage would have saved you a whopping $54,400 in interest payments. That’s a difference of $361,885 from what you would have earned had you left your money in the TSP. That’s a huge cost to pay on top of your tax bill!
Final Thought
Although saying goodbye to your mortgage can feel like a major financial accomplishment, it might not be the best financial choice. And while the emotional aspects of the decision are certainly important, careful consideration should still be given to the financial consequences of using your TSP to pay off your mortgage. This is why any time I sit down with federal employees, we evaluate both the emotional and financial considerations of any big financial decisions. So, before you make any choices that can have significant financial consequences, take the time to evaluate the complete scenario and consult with a qualified financial planner if you are not confident running your own analysis.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.
