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It is important to remember that a 401(k) loan is essentially money borrowed from yourself.
Is a 401(k) loan or other amount borrowed from a retirement account dischargeable in Chapter 7 or Chapter 13 bankruptcy? Can such a loan be included in your bankruptcy filing?
It depends upon what you mean by “included.” A 401(k) loan cannot be discharged in bankruptcy as can a commercial debt—but it must be disclosed.
It is important to remember that a 401(k) loan is essentially money borrowed from yourself. Failing to repay the loan does not result in a debt collector calling interrupting your dinner, lawsuit, or garnishment.
However, there are negative consequences—and bankruptcy may be of limited use in liming them.
First, however, what is a 401(k) loan exactly?
What Is a 401(k) Loan?
A 401(k) loan is a type of loan that allows individuals to borrow money from their 401(k) retirement savings account. A 401(k) loan is different from a withdrawal in that the borrowed amount must be repaid, typically through regular payroll deductions, over a specified period of time—with interest.
Additional characteristics of a 401(k) loan are:
- Eligibility: Like any loan, 401(k) loans have eligibility requirements. For example, a 401(k) loan may require that you be a participant in the retirement plan (duh!) or that you are an active employee of the company sponsoring the plan.
- Loan Amount: The maximum amount you can borrow from your 401(k) is generally limited to 50% of your vested account balance or $50,000, whichever is less. However, some plans may have different rules.
- Repayment Terms: When you take a 401(k) loan, you will typically have to repay it within a specific timeframe, usually five years. However, there are exceptions, such as use of the funds for home purchases, in some cases.
- Interest Rates: The interest rates on 401(k) loans are typically lower compared to other types of loans since you are borrowing from your own retirement savings. The interest you pay on the loan goes back into your 401(k) account rather than to a commercial lender.
- Repayment Method: Repayments for a 401(k) loan are usually made through automatic payroll deductions, meaning the loan payments are taken directly from your paycheck. This is crucial for understanding the effect of a Chapter 7 or Chapter 13 bankruptcy filing upon a 401(k) loan.
- Potential Penalties: If you fail to repay the loan according to the terms set by your 401(k) plan, the outstanding balance may be considered a distribution. In such cases, you may be subject to income tax on the outstanding balance and, if you’re under 59½ years old, a 10% early withdrawal penalty.
How Bankruptcy Discharges Debt Generally
For commercial debt obligations, the bankruptcy discharge is a complete solution, with very few exceptions.
The discharge itself is a “master” injunction enforced through court order at the conclusion of a successful Chapter 7 or Chapter 13 bankruptcy.
The bankruptcy discharge injunction prohibits all collections activity as regards those discharged debts. It also prohibits continuing negative credit reporting. Essentially, the bankruptcy discharge wipes your slate clean and allows you the opportunity to begin rebuilding your credit.
The debts that are discharged are, of course, those owed to others.
401(k) loans are, as noted, owed to yourself, or, at least, to the retirement plan managed by your employer and to which you contribute. They are, outside of bankruptcy, repaid, also as noted, through payroll deductions, along with your ongoing 401(k) or other retirement account contributions.
The Difference Between Chapter 7 and Chapter 13 Bankruptcy (Nutshell Version)
Chapter 7 bankruptcy is a “liquidation” bankruptcy. That is, it discharges your (dischargeable) debt entirely, without the need for you to repay any of it. However, in return for this enormous governmental benefit, some of your assets may be seized and liquidated.
Chapter 13, on the other hand, is a “reorganization” bankruptcy. In Chapter 13, you do repay your debt, at least partially (and sometimes entirely). This occurs by way of a payment plan drafted by your Michigan bankruptcy lawyer that is filed with the Federal Bankruptcy Court.
This Chapter 13 payment plan designates how much the monthly payment amount will be. It also designates which creditors will be paid in which order—and how much.
Both forms of bankruptcy require that all debts be listed on forms called Schedules.
Your monthly average household income and necessary household expenses are also list—and itemized on separate Schedules in both forms of bankruptcy.
In neither form of bankruptcy are 401(k) or other retirement account loans included in these debt listing Schedules.
Rather, they are list among the deductions from your gross monthly average income on the Income schedule—alongside your ongoing 401(k) contribution.
Chapter 7 Bankruptcy and 401(k) Loans
That last bit of information, above, should tell you something about how 401(k) loans are treated in Chapter 7 bankruptcy.
That is, they are not treated at all. They are not discharged. They simply contribute to the calculation of gross vs. net household income.
This is important in either Chapter 7 or Chapter 13 bankruptcy because this calculation constitutes a “good faith” test of your Chapter 7 bankruptcy eligibility (in addition to the dreaded Means Test).
If you have “too much” net income remaining after your average monthly expenses are deducted from your average monthly income, you will not be eligible for Chapter 7 bankruptcy regardless of what your Means Test says.
So a 401(k) loan obligation is, in a sense, helpful in this regard.
However, there is a downside as well.
This is the Means Test.
Briefly explained, the Means Test calculates your monthly household income by averaging all gross income earned by all household wage earners for each of the 6 months prior to the bankruptcy filing. Against this average total amount, certain “allowable deductions” are offset.
If your average income as a household is under the median income for a household of your size in your area, you “pass” the Means Test and may file Chapter 7 rather than Chapter 13 bankruptcy. If this is not the case, but your allowable deductions sink you under that median amount, you are also then eligible for Chapter 7 bankruptcy filing.
A 401(k) loan repayment obligation is not an allowable Means Test deduction.
Thus, a 401(k) loan can reduce the actual amount of income you bring in every monthly in reality, but your Means Test will not reflect this reality.
This is one of the many, many ways in which the Magical Land of the Means Test may not resemble the world in which you really live.
Call your Congressman or Senator to thank them for this bizarre end-result. Especially if that representative was in office in 2004, when the BAPCPA bankruptcy “reform” act creating the Means Test was enacted.
Chapter 13 Bankruptcy and 401(k) Loans
All of the above is just as true in a Chapter 13 bankruptcy as in a Chapter 7. Additionally, in Chapter 13, the presence of a 401(k) loan paycheck deduction on your income Schedule will create a slight hiccup in terms of your required Chapter 13 monthly plan payment.
That “hiccup” is the probable need for a “step-up” in your plan payment amount once the 401(k) loan is completed—if that loan is repaid within the term of your Chapter 13 plan (3-5 years).
Example: Your net income is $200.00 per month on the date that you file your Chapter 13, after all expenses and deductions are applied to your gross income, including your 401(k) loan deduction of $100.00 per month. However, your 401(k) loan will be repaid 12 months into your 60-month Chapter 13 plan. For the final 4 years of your Chapter 13 Plan, your plan payment will need to “step up” $100 to a $300.00 monthly total.
Including 401(k) Loans in Bankruptcy: The Bottom Line
The bottom line is that a 401(k) loan, or other retirement account loan, may not be dischargeable—but it is something than can make a difference one way or another and must absolutely be disclosed to your Michigan bankruptcy attorney.
Attorney Walter Metzen is a Board Certified Bankruptcy Expert who has successfully assisted thousands of Metro Detroit Chapter 7 and Chapter 13 bankruptcy clients for over 30 years.
If you are considering filing for bankruptcy, contact us now to schedule your free initial consultation.
