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LarryDem

403b loan question.

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I defaulted on a $2100 loan from my 403(b) back in 2006. It ended up being treated like a distribution and I got a 1099 that I filed with my taxes. Here it is 12 years later and my account still shows an outstanding loan balance of well over $5000. My latest statement says my account now has assets of around $4400. It also shows the loan balance mentioned of course. The $4400 is made up of two funds that I am invested in and something called a collateral account. The collateral account shows a balance of around $3700.  Can anyone explain why this loan has been continuing to amass interest after being treated as a distribution so long ago? Also, will I be able to withdraw the $4400 when I turn 59 1/2 or will this amount be affected by this outdated loan? And what is the story on this collateral account? I am wondering about this because I have been out of work for over a year and am waiting on a disability determination. I am quickly running out of cash and was wondering if this 403b is anything I could count on. Thanks for any help and info that anyone can share.

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Under the IRS Regulations, when a 403(b) loan is not repaid, it creates a taxable event.  In this instance, it caused what is known as a deemed distribution, which generated the Form 1099-R that you received.

However, because you had not yet attained age 59½, an actual distribution of cash to offset the loan could not be made due to the fact that a qualifying event  (death, disability, etc.) for a distribution had not occurred.  Thus, while you received a 1099, the loan actually remained on your account and continued to accrue interest.  Further, it will continue to do so until a qualifying event occurs, at which time a portion of the account balance will be used to actually repay the loan.

I suggest that you contact the plan administrator for details.  Since you mentioned that you're out of work, your separation from service is most likely considered a qualifying event that will permit an offset so the loan can be repaid and stop the accrual of additional interest.

I hope this helps.  Best of luck to you!!

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Hey Michael,

Great to hear from you. Thanks for superb contribution. I hope all is well. - Dan 

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Thanks, Michael.

Since I made the loan to me and would supposedly be paying myself the interest, just how much, and why, would I have to pay to settle the loan? This part really confuses me. 

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Well, it's not quite that simple.  It's a common misconception that a qualified plan loan constitutes the borrowing of the participant's money.  The loan is actually made as a separate transaction using the account as collateral.  The value of your account continues to fluctuate based on investment gains and losses.  The loan, on the other hand, is separate and likely bears a fixed rate of interest.

It's similar in some respects to a car loan.  When you purchase a car, you sign a loan agreement stating that you'll repay the loan over Y years at % interest.  You're obligated to repay the loan regardless of what happens to the value of the car.  For example, if the car is "totaled" in a wreck and it's value reduces to nothing, you still have to repay the loan.

In the same respect, your 403(b) loan is an agreement to repay the lender interest at the specified interest rate.  While you're using your account as collateral for the loan, you're not actually borrowing "your" money, so you're not paying interest to yourself.  Rather, you're borrowing money from the plan and the plan is the entity earning the interest.

Like I said earlier, your plan administrator should be able to tell you how much it will take to settle the loan.  Depending on the investment results of your account, the loan repayment could exceed the account value.

HTH.

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Michael, 

When stated that way, it seems as if your entire account balance is subject to compounded gains (or losses). Is that correct?

Do the monthly repayments get added to your balance as you pay? (Minus the loan interest.)

Thanks for your input.

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I'm sorry for not responding sooner, MoeMoney.  I've been away from the office for several days.

I used the example in an attempt to simplify the discussion.  In doing so, the over-simplification might be a bit misleading.  I've seen loans work "mechanically" in a couple of ways.

In one, the account balance does, indeed, continue to be credited with earnings.  However, the portion used to collateralize the loan is charged with interest at a rate that's a bit higher than the rate being credited to the account.  Thus, while the account balance increases, the loan increases at a greater rate.  Upon default, the account continues to be credited with earnings, but the loan also increases with interest until an offset can be made.  It's easy to see that at some point, the entire balance may be "upside-down," where the loan plus accrued interest is more than the account value.  This method is typically used on accounts that credit a fixed rate of interest.

In the other method, the amount issued as a loan is actually taken from the account value.  Since the money is no longer in the account, it of course is no longer subject to gains/losses.  The loan is charged a rate of interest, such as prime plus 1%, and when loan repayments are made, the principal element is returned to the account value while the interest element is paid to the entity administering the loan.  If the loan is defaulted, it continues to grow at the specified interest rate until an offset distribution is available.  Depending on the earnings of the account, this, too, can cause the unfortunate situation where the loan exceeds the account value.

In either case, the loan causes a reduction of the future value of the account below what it would have been had the loan not been made.  This is one of the primary reasons not to take a loan from a 403(b) or any other type of retirement account.

I hope this answers your question.

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