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The 403(b) Loan: The New Debtors Prison?   by G. Wade Caldwell
The pitch from the annuity salesperson is so alluring it is hard to resist. Take out a loan against your 403(b) and pay off high interest debt, such as credit cards and car loans. The interest rate on the 403(b) loan is much lower, and better, you are using pretax money to pay off the loan. Yet, for those unaware of the restrictions on these loans, a financial disaster can await.
 
  Debt consolidation plans were developed in the 1990's by marketing groups out of Austin, Texas as a new way to sell annuities to teachers. This marketing technique has spread from Texas to California, and other states where school districts do not screen vendors. Of course, the annuity salesperson only makes money off a new sale, not by helping a client arrange for a loan from their existing 403(b). Therefore, these marketing groups have devised elaborate "plans", to show you how you can afford to pay off your credit card debts, if you will invest with or roll your money over to their company. Thus, with the main motivation understood, one should look long and hard before plunging into a plan that can leave you in financial ruin.
 
The problem with 403(b) loans and debt consolidation plans are:
  1. Most 403(b) loans have to be repaid within 5 years (30 years if used to pay for a new home). If you default on the loan, the unpaid balance is treated as an early distribution from your 403(b), triggering taxes and a 10% penalty.
 
  2. Worse, IRS restrictions on loan repayments are very severe. Missing even a single payment can trigger a loan default, and the loan cannot be reinstated.
 
  3. When you borrow out of your 403(b), it reduces the amount you accumulate for retirement. In addition to the loan interest, some annuities even pay a lower rate of interest on funds which are set aside under a 403(b) loan.
 
  4. Even if you take out a small 403(b) loan, do not think that defaulting on it can have small consequences. Most companies treat the loan as being outside of your annuity, so the loan continues to accumulate interest until you decide to withdraw your money or the loan balance equals your annuity value. Some teachers may not realize the loan they defaulted on years ago is continuing to accumulate interest, rather than being debited against their annuity at the time of default.
 
  5. Most 403(b)'s already allow for loans. You do not need to move your money to get a 403(b) loan, in most instances.
 
  6. Many debt consolidation plans provide for dramatic increases in the monthly contribution to the 403(b). This has the effect, not unintended, of also dramatically increasing the salesperson's commission.
 
  7. The 403(b) loan has another consequence, also not unintended, of locking you into that company. In most cases, the loan has to be repaid before your money can be moved to another company.
 
  8. Some agents even talk buyers into signing blank W-4 forms and changing their withholding. The pitch is that you will now be in a lower tax bracket because you are contributing so much to your 403(b). In fact, if your spouse has significant income, or if you do not carefully do the math, you could end up under withholding. Further, once your level of withholding is altered, you have to monitor this every year for any changes in your income. Some of the companies selling debt consolidation plans have taken a very questionable position about the amount they can loan from a 403(b). These companies include the amounts you have in the Teacher Retirement System to calculate how much you can borrow under IRS guidelines. If this interpretation turns out to be incorrect, the IRS may hold you responsible, even though the company said you could do it.
 
  Finally, for those already having a difficult time managing their level of debt, debt consolidation plans can be a lead life preserver. While the plans may have some merit in getting out of debt on a one time basis, they can also erode the discipline required to stay within one's budget by encouraging borrowing out of retirement savings. While you may have gotten yourself into a prison of debt, a mis-sold or badly designed debt consolidation plan can throw away the key.
 
G. Wade Caldwell is an attorney with Martin, Drought & Torres, Inc. in San Antonio, Texas. Mr. Caldwell has represented numerous teachers on suits involving 403(b) investments and other insurance products, which are described at www.mdandt.com.
 
 

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