Okay I figured it out.
Basically my problem was that i was using a very old /etc/init.d/saslauthd script and it doesn't really listen to /etc/default/saslauthd. so basically switched out for the saslauthd.dpkg-dist file and everything now works.
This post seemed to guide me through what was going on: http://www.howtoforge.com/forums/arc...hp/t-2199.html
Since it wasn't obeying /etc/default/saslauthd it wasn't chrooted inside of postfix so it couldn't authenticate anyone since it can't read who to authenticate.