Current Pension Topics
Consequences of Loan Default

By JOEL L. FRANK

Q.: I am 42, a Teacher and have defaulted on my Teachers' Retirement System 403(b) loan. I have paid all the tax and penalties and whatever else the government could get out of me for the default. I contacted TRS and inquired as to why the loan still shows on my statement, and is still increasing (accruing) in interest. I was told that this will continue until I quit my job or retire and that I do not need to worry about it. I will not have to pay it back. I was also told that I may not pay it back because the loan is defaulted. This makes me nervous, because why are they still keeping track of it, if it is something that I will not be held responsible for in the future? Could you please fill me in on what I have gotten myself into and how should I handle it from here?

Mr. Frank is a fee-only Retirement Financial Planner. He can be reached by telephone at (732) 536-9472, or via e-mail at rollover@optonline.net .

P.A.

A.: Defaulting on a plan loan is a complicated matter that's addressed in the Income Tax Regulations. When you default on a loan, you receive a Form 1099-R that represents a taxable event. You have to pay taxes and appropriate penalties on the amount of the defaulted loan. However, since no cash is received on a defaulted loan (the loan amount was previously sent to you), the IRS refers to it as a "deemed distribution." This means that you have to include the defaulted loan in gross income and pay any tax and penalties due.

In order for the loan amount to be reduced to zero, you need to be entitled to take a distribution. Section 403(b)11 lists the earliest dates upon which a distribution can be made from your account; they are: severance of employment, attainment of age 59-1/2, death or disability. Because of these distribution/withdrawal restrictions TRS TDA cannot reduce your account balance by the amount of the defaulted loan without you first satisfying one of the enumerated qualifying events. When one of these qualifying events occurs, only then can the loan principal be reduced to zero. That is known as an "offset distribution," since the account balance is reduced to offset the amount of the loan.

Until this offset distribution takes place, the loan amount has to remain on the account, even though you've included it in your gross income and paid tax on it. Hopefully, the account value that's securing the loan is accruing interest/gains at a greater rate than the rate of interest charged for the loan. Loan interest will be added on for each of the next 17 years, assuming you continue your active TRS membership until at least age 59-1/2. The accrued interest will be reducing the value of your account for each of the next 17 years. This is an abusive income tax regulation and must be repealed forthwith. Regardless, only when one of the qualifying events listed above occurs will the loan and accrued interest be deducted from the account.

Moreover, while the loan is intact, it will impact your ability to take additional loans. And, since you defaulted on the original loan, you will have to make special arrangements to repay any new loan.

Having said all that, this mess is another reason not to borrow from any pre-tax account. Additionally, it's another example of the United Federation of Teachers being sound asleep at the switch. All that is needed to solve this problem is a law that allows the TRS TDA Program to reduce the loan principal to zero (an offset distribution) without the participant first having to satisfy a distribution event (severance of employment, attainment of age 59-1/2, death, or disability). I'm shaking the UFT ... Shake, shake, UFT ... Get up and request that the Congress grant such a limited exemption to the restrictions of section 403(b)11. Get it done this legislative session. C'mon, get up, you're going to be late to school!