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Debtor Take Note: The Treatment of 401k Loans in Chapter 7 and 13 Bankruptcy Cases

Millions of Americans have 401k plans: retirement plans that allow employees to contribute a portion of their wages to individual accounts on a pre-tax basis. Distributions (including amounts deposited and earnings on such deposits) are not taxed when deposited or earned, but are generally taxable income when the funds are withdrawn – typically, after retirement when the earner is likely to be in a lower tax bracket. But sometimes life upsets this plan. An employee (or former employee) who is faced with mounting debt might think about taking out a 401k loan to pay off creditors or at least to keep the household going.

However, if despite taking out the 401k loan, the person in debt still files bankruptcy, the ramifications can be worse than if the 401k loan was not taken. This is because in bankruptcy most 401k deposits are “exempt,” meaning that the debtor keeps the 401k free from creditors’ claims so it is still available for retirement. But a 401k loan isn’t repaid from the non-exempt assets that a trustee liquidates for creditors in Chapter 7.

The Bankruptcy Code defines “debt” and “claim.” A “debt” means “liability on a claim.” A “claim” means a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” Despite the seemingly broad definitions of “debt” and “claim” under the Bankruptcy Code, 401k loans do not qualify under either for bankruptcy purposes.

The reasoning behind this is the theory that when someone borrows money from her 401k loan, she is essentially borrowing money from herself. In other words, the person’s obligation is essentially a “debt” to herself. If she does not repay the 401k loan, the retirement plan administrator has no right to payment against her. Instead, the outstanding 401k loan balance will be treated as a distribution of funds, thereby reducing the amount available to her from her 401k plan in the future and resulting in immediate tax consequences (the “loan” becomes a distribution which is taxable now, not at retirement) and penalties. Because there is no personal recourse against her for her failure to repay the 401k loan, a debtor-creditor relationship does not arise. Accordingly, a 401k loan is not a debt in bankruptcy cases.

Anyone interested in possibly filing under Chapter 7 or 13 should take into consideration that although Chapter 13 debtors may deduct 401k loan repayments from their disposable income calculation, a similar exemption is not available for Chapter 7 debtors. Unlike a Chapter 13 debtor, a Chapter 7 debtor cannot deduct 401k loan repayments from disposable income for purposes of the means test calculation. Thus, someone with a large 401k loan repayment oftentimes might not qualify for Chapter 7 relief under the means test, and might be forced into a Chapter 13 repayment program.

If you are considering taking out a 401k loan, you may be in deeper financial distress than you realize. Before taking out a 401k loan, contact Donahoe & Young LLP for a no-cost, no-obligation consultation to evaluate your alternatives and assess how the 401k loan could limit your options for future debt relief.

Written by: Maria L. Garcia

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