The TSP Loan Guide, Part 2: Pros and Cons of TSP Loans


What are the advantages of Thrift Savings Plan loans?

(1) The interest rate is very low and you are paying it to yourself instead of to a bank. So the loan is essentially free to you, other than a small administrative charge.

(2) You avoid the 10 percent penalty on early withdrawals from retirement accounts. If you aren’t old enough, or are old enough but haven’t separated from federal service, you would have to pay this penalty if you withdrew the money outright.

(3) The fee charged for TSP loans is a very low, flat fee of $50.

(4) The TSP loan application is quick, easy and straightforward. No one is turned down for a loan assuming sufficient employee contributions and earnings. No credit check is required. Other types of loans require a more complex application process, a credit check and more fees.

(5) There is no negative impact on your credit score. A TSP loan does not appear on your credit report, because it is not really a loan (you are using your own savings). If a TSP loan borrower loses his or her job, retires or leaves federal service and is unable to pay off the loan balance, the unpaid balance will be classified as a distribution for which income taxes must be paid, but it will not show up on your credit report as a default.

What are the disadvantages of TSP loans?

(1) The most significant disadvantage is missed opportunity. The most powerful feature of a retirement plan like the TSP is the tax-deferred growth and compounding of earning. Removing funds from your TSP account can significantly affect its growth. The inevitable result will be a smaller TSP balance at retirement, which will impact the way that you live out your golden years.

For example, lets say you took out a $50,000 residential property TSP home loan at the current interest rate of 2.125% and paid it off over 15 years. At the end of those 15 years you would have paid back $58,500 (and earned an additional $950 in interest on the principal after you paid it back). Your nest egg would have grown by only about $9500 in 15 years, and nearly all of that money came out of your pocket. Compare that to $50,000 compounding at 10.6% (the stock market’s average rate of return over the past 25 years). At the end of 15 years you would have $243,481.

(2) Potential tax penalty. If you fail to pay off a TSP loan, income taxes on the “distribution” will be due. An additional IRS early withdrawal penalty of 10 percent will be applied if the account owner is younger than age 59.5 at the time of the loan default.

(3) A TSP loan of either type is not a mortgage. Therefore, the TSP loan interest payments are not tax deductible, as they might be for a mortgage or home equity loan.

(4) If you leave Federal service, you must pay off the loan within 90 days of the date when your agency reports your separation to the TSP. Any unpaid balance will be reported as a taxable distribution

The “Double Tax” Myth of TSP Loans

In the “Disadvantages” section of most websites which address TSP loans, the authors usually blindly copy some original source which incorrectly stated that taking a TSP loan results in paying taxes twice because the TSP account holder is moving tax-deferred assets into the taxable realm and after-tax income must be used to repay the loan. Suze Orman popularized the notion while discussing 401K accounts (which have the same tax treatment as the TSP) and this myth is widely spread across the internet.

Let’s say you want to borrow $10,000 from your Thrift Savings Plan account for a year. The TSP G Fund interest rate at that time is 5%, which you must pay back to yourself. That $10,000 was a pre-tax contribution, so you never paid income taxes on it. You take it all out, leaving yourself with $10,000 in cash. You haven’t paid any taxes on that $10,000. You leave it under your mattress, and a year later pay back the same $10,000 plus $500 in interest. You still haven’t paid taxes on the $10,000. When you eventually withdraw the money, then you finally must pay taxes. So what was the only thing taxed twice? The part attributable to the $500. Not the $10,000.

Now, does it matter if during the year your brother took the original 10,000 and then later replaced it under your mattress with a different $10,000? The answer is no. As long as you pay back the $10,000, that is all that matters.

The only part that is taxed twice is the interest. And since you are paying yourself the interest, this small double-tax is really the only cost of doing this loan. Using the example above and assuming a 25% marginal tax bracket, that means you only got taxed an extra $125 on that $10,000 loan. This is the same as getting a regular loan with a 1.25% interest rate.

Continue to TSP Loan Guide, Part 3: Eligibility and Application

 

46 thoughts on “The TSP Loan Guide, Part 2: Pros and Cons of TSP Loans”

  1. Loan repayment is taken out after tax isnt it? So would you then be paying taxes on that amount twice, once when you repaid the loan amount and then when you retire?

  2. It is hard to wrap your head around and can be argued lots of different ways, but in the end the only money you pay taxes on twice is the interest which you pay to yourself (you are taxed when you receive it as income and again when you receive it as a distribution from your TSP). But that’s the case in every non-tax advantaged investment you ever make – every stock and fund I buy in my regular brokerage account is with after tax money and I will pay taxes again when I sell that asset. But that doesn’t mean that those investments aren’t a great use of that money.

  3. This article is somewhat misleading. As you repay your loan, the money goes right back into your TSP to make earnings. They are not holding your money out until you pay the full balance and then putting it back in. For instance, if you borrow $50,000 over 10 years…. After 5 years, half of your money is back in your TSP making earnings, towards the end of your loan, almost all your earnings are back in TSP making returns. It is inaccurate to say that you would only make about 2 percent during the length of the loan. The truth is you will only make about 2% on the outstanding balance of your loan, while the amount you have repaid is back to making money with the rest of your account. Also not mentioned is the flip side…. If the market tanks, then the money you have borrowed is protected and making about 2%, while everything in your account is going down. And the market going down soon could be a reality, I think this article is putting a negative spin on a great feature of the TSP. It has risks of course, but this article doesn’t fully explain the math of the interest made on the portion of your loan you have paid back.

    1. I did leave out the compounding returns on the principal which the borrower repays and will make that change that above. But it turns out to be a fairly insubstantial amount – less than $1000 in my hypothetical example above when the borrower pays back $3333 per year and it is compounded at 2.125%. That $59,500 at the end of 15 years is still $184,000 less than the borrower would have had if they had been invested in the stock market.

      With respect to the potential flip side benefit you mention, the longest bear market in history was four years long (and most are only a few months), so it is exceedingly unlikely that the benefit of having a substantial sum out of the stock market for 15 years would result in a net benefit.

      Don’t get me wrong, the ability to take a TSP loan in an emergency or for a short term bridge is a great feature. Unfortunately, most people who borrow from their TSPs or 401Ks do so for the wrong reasons and keep their money out for much too long.

      1. It is still somewhat misleading to compare a G-Fund TSP with a compounding interest of 2.125% vs stock market interest at 10.6%. The large difference has to do with the rate of return rather than the loan itself. Wouldn’t it make more sense to compare a TSP with a different fund that has a higher rate of return if you had left it alone vs taking out a loan and repaying at the G fund interest rate? In this case, the repayment money would be reinvested at this higher rate of return, not at the G fund interest rate.

        1. That’s a good point. When I get a minute I will rewrite to reflect what the difference would be if the loan payments went into a fund returning the average returns I was comparing against. It will still be a big number, but considerably less than the current one. Thanks for the insightful comment.

    2. Kevin,

      thanks for the explanation.their explanation did not sit right with me. You hit the nail on the head for me. danke gary

  4. I am looking at my pay stub and when i pay back my tsp loan I am paying it back with after tax income so the money I am paying back is taxed at my tax bracket i am now as i am repaying it. I should not then when i retire pay more tax on anyportion that i paid back because of aloan becuase that money was taxed when i paid it back with after tax dollars. I am very surprised that this is allowed since tchnically this money is not supposed to be taxed until I retire or if i make an early withdrawal. The loan payments should be using pretax money. this is currently not how it is.

  5. You’re over thinking this. Forget for a minute that the money is borrowed against you’re account. If you borrow 10K you can think of it as an advance on your pay, you get the 10K now instead of spread out ofver the time you repay the loan. And you pay tax on your income the same as you would if you got it over the course of the loan instead of as a lump sum. So, you are getting 10K of your income in advance and you pay the tax on your income the same as you always would.

    To double tax it would mean that you get 10K minus 10K times your tax rate when you take out the loan and then pay it back with after tax funds. That is not what happens.

  6. I have taken 2 TSP loans in my career and both were to pay off higher interest rate loans. In both cases, the amount of interest saved was far more than the amount I was earning on the money I still had in the TSP…making the loans a net gain after the fee and after paying myself interest. I am currently at about $70,000 on my mortgage (which I over pay monthly). Once I get to that magic $50,000 remaining on my mortgage, I will take a TSP loan out for that amount and pay off my house…and make myself technically “debt free”. I will then make monthly payments of $406 for the next 5 years…paying myself $2,780 in “interest along the way, compared to the more than $7,600 I would pay to the bank.

    The other possibility is to take a loan during the next correction or recession and then invest that money into a Roth IRA holding a Vanguard S&P-500 index fund and ride the wave up in a tax free vehicle. I will never have paid taxes on the money borrowed from the TSP that I then invested in a Roth IRA.

  7. The whole idea is totally situation dependent. I took $50k out of my TSP on a “loan” (its not really a loan, its your money, with certain tax classifications), used that $50k to build a new house, flipped the house for a $65,000 gain, repaid the $50k, and reinvested the $65k. Then I did it again. Whole process took 18 months. Not saying I’m a genius, but it totally depends on what you do with the money. Use it on a vacation? Thats your choice and the money is gone. Neither way is right or wrong, it is just situation dependent. Suze Orman? Dave Ramsey? They preach no risk methodolgies.

  8. ok, so I get the concept of not being “double taxed” but there is something to be said about paying the loan back with after tax dollars, considering you pay into the system with pretax dollars. what is the impact?

    it seems the confusion is simply semantics, us laymen wee equating the idea of paying back with after tax dollars as a version double taxation.

    so again, what if anything is the real financial impact of paying back pretax loan money with after tax dollars?

    And why don’t they allow you to return the money from pretax dollars?

  9. There is no double taxation. The “loan” money is, was, and will continue to be tax deferred until you permanently withdraw it after age 59.5. There is no financial impact because the pot of money is tax deferred until then. The payback money is from your income and is in a different category of taxation status. $50,000 tax deferred money is still $50,000 tax deferred money after you pay it back.

  10. I don’t know why I’m having a block on this. When you pay into the TSP, the money comes out of your check, pre-tax. It goes into the “pot” of your TSP, and your income is reduced and you pay less taxes in the end b/c of the reduction to your taxable income. If you take out a TSP loan, you are not taxed on the distribution (as you would be with a straight up liquidation), and you have that 50K in your bank account to use for whatever reason. You don’t pay taxes on it or the penalty. It was your pre-tax money going into your account and remains tax free.

    At this point, I get confused with the semantics. If I originally put in the money pre-tax, why is REPLACING THAT SAME MONEY done with post-tax dollars, with no corresponding reduction in taxable income. Surely, you should REPLACE the same tax free money you borrowed with more tax free money.

    In other words, if I never took the money out, never got the loan, but decided to increase my contributions by an arbitrary amount–say, the exact same amount of the loan payment per month (say, 50K loan with $407/pay period pay back), the increase in contributions (approximately 21K) would be made pretax and would also reduce my taxable income by 21K.

    But here, replacing the tax free money I took out of the pot is paid with post-tax money. I pay taxes on the 21k that I’m putting back into the pot, and it didn’t decrease my taxable income. Can someone use plain English to explain how this is not a serious difference, with tax consequences and double taxing.

    1. Look at it like this: if you replace the money you borrow with post-tax money, that means you never pay any tax at all on the money you borrowed and spent. Zero tax. That balances out the “double tax” you are concerned about and results in your paying tax once on average.

      1. The issue with this example is that you are forgetting about the taxes taken out when you start your retirement withdrawal. So, in effect you are paying taxes on the money for the loan payment and then are paying taxes when doing the retirement payouts. This just sounds like the loan repayments are actually going into a ROTH and not into a tax deffered account. Something fishy about this.

  11. Michelle could not have explained it any clearer. That scenario is spot on why I do not understand why the amount I repay is not excluded on my taxable income for any said year that payments are made.

    1. Had the TSP loan never occurred, you would be paying your marginal tax rate on that sum of money at the time of its distribution after your 59 1/2 B-day. When you take a TSP loan and spend it, no income tax would have been collected on those monies after they were earned. Hence, the loan monies that would have otherwise been taxed in a retirement distribution are being repaid with present after-tax money. If TSP loan money was perpetually repaid with pre-tax money, the GOVT would never get its piece of the action (not at the time of earning or disbursing). Either way, that chunk of money, whether it be disbursed in the form of a loan and repaid with after-tax money or a retirement distribution taxed as income, it will be taxed once. Except for the loan “interest”. I put interest in quotes because its really an add-on contribution to your retirement account. The real cost to worry about is the opportunity cost of a market boom while your in the process of repaying the loan. The unpaid portion of the loan monies don’t generate earnings beyond the “interest”. The opportunity cost is lessened if the loan monies are used to pay down high interest (if you’re in a crunch), to house you (besides providing a roof over your head, real estate can provide a gain), etc.

  12. I too am having difficulties understanding what was presented for the double taxation. I will try to explain it another way which makes sense to me. If you took out a 10k from your tsp you have 10k in your hand. If you were to save 10k from your salary it would take X months/ X years. This money is after tax money. The real benefit is having money up front for what you would have saved for over time using after tax money anyway. The real reason you take out money is you need it so the time value of money is important here. If you don’t need the money then the best option is to leave it and let compounding interest work its magic.

    To throw a wrench in the situation, how does this work with ROTH TSP? I read somewhere that an equal percentage is taken out based on the type of money in your account. For example if you contributed 80% traditional and 20% roth then your loan is 80/20. I haven’t given it much thought but never employees that have only known the ROTH TSP would be at a great advantage over seasoned employees.
    *All govt matching is traditional TSP

  13. Is it true that if you are definitely taking out a TSP loan, that it is better to do when the market is low vs. high? Really appreciate an answer.

    1. The key is what the market does while your money isn’t invested because you have it out as a loan. I suppose that in a perfect world you would take at the loan right at the market’s peak so that money wasn’t invested during the decline. But of course there is no way to time that and peaks and troughs are usually years apart so if you need to take out a loan it would be tough to plan around that.

  14. I agree w. TS Paul. In my opinion, it doesn’t make one bit of difference what the market is doing. Keep track of how much you’ve put in vs how much youve made (basic cost basis accounting). Then make a decision as to how much you are going to use/take out via “loan”. It’s not really a loan, because it’s your money, just classified differently for tax purposes with some very distinct rules.

    Good luck
    Fred

  15. Thank you. I was planning on taking out a loan to pay off credit card debt (no need for advice and criticism in this area, I’ve already researched and made the decision.) I hesitated and the market went way down. I’m wishing I would have taken out the loan when I first considered it and was now rebuying in at the much lower rate. I saw conflicting info on whether low or high was better. I’ve made the mistake of putting WAY too much in while incurring credit card debt at the same time. Stupid, I know and now need to readjust.

  16. The example of not paying taxes twice seems not correct to me. You did not take out $10,000 from your TSP to put in under your mattress–you took out the TSP “loan” to more than likely spend it. If you are in the 25% marginal tax bracket you now will have to earn $13,333 gross, pay $3,333 in taxes to net $10,000 to pay back to your TSP for the loan. Then some day when you withdraw the $10,000 from your TSP as a taxable distribution you will pay your marginal tax rate on that again. What am I missing here???

  17. In your example, you have some need for $10,000.

    Case #1: Save $10,000 from working (taxed) income. Use $10,000.

    Case #2: Use $10,000 from your 401k. Pay it back from working (taxed) income.

    In both cases, the $10,000 was taxed 1 time and 1 time only.

  18. Fred when you ultimately withdraw the $10,000 from the TSP that you replaced after the loan the $10,000 will be taxed again. For the loan re-payment from post tax dollars–You paid tax on the $10,000 when you earned it and paid tax again when the $10,000 was ultimately withdrawn from the TSP account.

    Scenario: Not using the $10,000 from your TSP as a loan and it gets taxed once only when you withdraw it. No tax has ever been paid on this $10,000.

    My point is that when you take a TSP loan you should be able to pay it back from payroll deductions pre-tax just as when you initially placed it in your TSP account

    Example: you are in a marginal tax rate of 25%. Over age 59 1/2 no early withdrawal penalty.

    1. No TSP loan–just withdraw $10,000 from your TSP at ultimate retirement time/or distribution time and pay $2,500 in tax on the distribution.

    2. Take a $10,000 TSP loan. Pay it back with post tax dollars with payroll deduction or other funds/income that were already taxed.

    You need to earn “gross” $13,333 in earnings to net $10,000 to pay back the TSP loan. You paid $3,333 in tax.

    Now when you ultimately withdraw that $10,000 at retirement time or post age 59 1/2 (no penalty, but say you still are in the 25% tax bracket). Withdraw $10,000 that was placed back in with the loan repayment, and you have to pay $2,500 in tax on this withdrawal.

    Total tax paid to use your TSP loan of $10,000 is the $3,333 (tax #1), plus $2,500 (tax#2) = $5,833.

    Sure looks like double taxation to me.

  19. Patrick, I can certainly appreciate that it seems like double taxation based on your presentation. I believed it too for many years until I actually did the math and realized it’s actually not. If the IRS allowed a person to take a loan and then pay it back with tax deferred dollars, you would be exceeding the tax deferral limit. Take an example of someone who starts contributing to their 401k for the first time in 2015 and maxes out their 401k in 2015 with $18,000. On Jan 1st, 2016, they take out a loan for $9000 (50% rule) while continuing to max their 2016 contributions. If they paid back the $9000 in one year tax deferred along with their 2016 $18000, they would have tax deferred $27000 for 2016 plus the original $18000 for 2015 for a grand total of $45000 tax deferred in 2 years — that would be an awesome deal! I would take out $50000 as many times per year as possible and pay it back with more with more tax deferred dollars in addition to my $18k contribution. Now that would be a smoking deal, if allowed, but it’s not because we are only allowed to tax defer a limited amount.

    The fact that you are replacing previously tax deferred dollars with current or future after tax dollars is actually irrelevant mathematically. Try reading this explanation for a different viewpoint:
    https://thefinancebuff.com/401k-loan-double-taxation-myth.html

  20. After reading all comments, Fred nailed it. It is not double taxation to repay a TSP loan with after tax dollars. You can’t deduct TSP loan payments because you deducted it once already when you originally deposited the money.

  21. I would disagree about hitting it on the head. Paying back a loan of 9k with after tax money doesn’t increase the actual tsp in the account. You removed it and just put it back therefore what it really amounted to was borrowing your own money for a little bit. True you would exceed the federal limit for the year but it’s a loan repayment so there really is a zero sin gain

    1. Another way to say all this is:
      “Any amount you pay to the TSP that is not replacing part of what you were loaned (i.e., the interest component of your biweekly payment, and your loan processing fee) is taxed twice.”

      P.S. — Thanks for a great article! You really put my mind at ease regarding my TSP loan.

  22. I see what’s really going on here:

    You work, get $10,000, then $10,000 does not get taxed yet, but, rather, goes straight into your TSP account. Then you take a $10,000 loan out, and spend that money. That money was never taxed, but you got to spend it anyway (You just bypassed taxes, congratulations… but wait). Now you are supposed to pay back that money. If you fail to pay back that money, then you will owe taxes on it. If you do pay back that money, then (according the the customer service associate that I just spoke to on the phone) your income will be taxed out of your paycheck first, and then be used to pay back the loan. So you have to make ($10,000+interest)/(1/1.(tax rate here)) so that when it is taxed, you will have $10,000 to pay the loan back. Otherwise you would have made, and spent $10,000 without ever being taxed.

    ex: 25% tax rate and 1.75 interest rate means ($10,000.00+$175.00) / (1/1.25) = $10,175.00 / 0.8 = $12718.75.

    This means $12718.75 is how much money you have to make before taxes so that when it is taxed at 25%, you will end up with the $10,175.00 you need in order to pay back the loan. That is hypothetical, of course, for simplicity.

    If your income did not get taxed before paying off TSP loans, then you could do it again. Take out $10k, spend it, pay it back, over, and over, and over, 90 times and never pay any taxes on any money you use to pay off loans…….until you retire… at which point, you take the $10k out, and pay taxes on that. Then you only paid taxes on $10k but none of the $900k that you made and used for paying back TSP loans.

    That would be nice to not pay taxes now wouldn’t it? But nope. That darn IRS just wouldn’t like that one bit, would they?

    So yeah, what’s really going on here, is that the owner of this website if making a lot of money off of us trying to figure out a problem that they caused by not explaining the situation correctly. You can tell by how this is a .com(commercial) rather than a .gov(government) website. If it was a .gov website, we could sue them for tons of money for giving false tax law information in the 12th paragraph (3rd to last paragraph).

  23. What people here aren’t appreciating is the overall “pot” of their money. If you are looking at your dollars as physical pieces of paper that are taxed versus your entire pot of money being taxed, then yes, technically, your repayment is taxed twice. They physical dollar that you use to repay your loan is already taxed and will be taxed again upon withdrawal. What people are failing to realize is that they are ignoring the fact that their “loan” dollars have never been taxed, and everything that they use those dollars for will be purchased with money that has NEVER been taxed. If you can’t take the overall perspective of dollars-in vs. dollars-out with regards to taxes and choose to separate the loan money from the repayment money, then yes, you are paying taxes twice in one place and not paying taxes EVER in the other.

    For example, imagine that you have two bowls of money. One bowl is empty, and the other is full of $10,000 worth of POST-TAX savings. You opt to take out a $10,000 TSP “loan” so that you can buy a car without liquidating your savings account. You take the $10,000 of PRE-TAX dollars that you received from TSP and place it in the empty bowl. You now have two (oversimplified) choices with regards to how you are going use your $20,000 in total cash to pay for your car (assuming no other money enters or leaves those bowls).

    Choice 1: Pay for the car with $10,000 of your pre-tax dollars and repay the loan with $10,000 of your post-tax dollars plus post-tax interest.
    Choice 2: pay for the car with $10,000 of your post-tax dollars and repay the loan with $10,000 of your pre-tax dollars plus post-tax interest.

    Regardless of which option you choose, you are paying taxes on $20,000 worth of cash. You could combine the two bowls, and the outcome would be the same. As several others have stated, the only real tax loss is the fact that you are using post-tax dollars to repay the “interest” on the loan, and you will get taxed again on that “interest” plus anything that it has earned when you withdraw it at retirement.

    The only way that you can justify claiming that you are paying taxes on the money twice is if you are unable to see the “big picture” regarding your overall cash flow and are unable to recognize that paying taxes twice on that money (huge loss?) means that you get to spend untaxed money (huge victory?), and those cancel each other out…

  24. Thank you so much for clarifying the double taxation nonsense that Suze Orman and others push. I don’t know why they can’t understand this. Funny, when working this out in my own head, I used the exact same mattress scenario…what would happen if I borrowed the money for one minute and then returned it? Would I be double taxed? Of course not! There is no difference between holding the money for a minute or an hour or a decade. Only the interest is in fact double taxed.

    Thanks again.

  25. thanks for this article. I took out a TSP loan and I am getting ready to pay it all back in a lump sum. When I called the TSP to get my payoff balance, the person I talked to mentioned the “double tax” – I didn’t think it made much sense for the reason you explained above. Just nice to also see it laid out so logically! Thanks.

    1. Question re paying off loan in lump sum. Should I go ahead and pay back now while market is high. I have the funds ready – about 15,000. But I could wait until the market is down. Would it be better to wait?

  26. Only you really can tell what is best for you in your situation. If you choose to pay it back (to yourself), and are concerned about market conditions, you can always recontribute to the g-series which will then protect your capital.

    R
    Fred

  27. Having taken a TSP loan, is it better to repay at a nominal rate and continue a 15% contribution, or reduce contributions to pay off the loan quicker? Thanks!

    1. You never get another chance to make up for contributions you didn’t make, so I would continue to make contributions and only pay ahead on the loan if my contributions were maxed out.

  28. Here’s the only way it made sense to me to explain the Double Tax question. If I borrow $10,000 and take the check and turn around and pay it back using the check, I’m only out the $50 application fee and no taxes are involved. If I pay back the $10,000 using my income and I’m taxed at 20%, I’m paying back $12,000 ($10,000 to TSP and $2,000 to IRS) but I am still holding the $10,000 check and paid no taxes on it. So, I’m only out the $2,000 in taxes for the $10,000 in income which I would have had to pay the IRS anyway on what I made and I still have the $10,000 check which I have paid no taxes. It seems like I’m being taxed twice when I withdraw the $10,000 later but I’m not. Sometimes a guy just has to type it out in an argument for it to make sense. Glad I didn’t send the original post…. Did you the one about the 3 people who got a hotel room for $30 ($10 each) and got $5 back because they were overcharged? The Bell Hop taking the money back to the room for the 3 people decided he couldn’t split $5 three ways so he kept $2 for himself and gave each person back $1. So that meant each person pad $9 each for the room which would be $27 total they paid for the room and the Bell Hop kept $2 which would be a total of $27 + $2 = $29 for the Hotel Room. Where did the other $1 go???

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