Bankruptcy and Your 401(k) Loan
401(k) loans are treated differently in Chapter 7 bankruptcy than they are in Chapter 13 bankruptcy. And by “401(k) loans” I mean any deferred compensation loans–403(b)s, 457s, and other similar qualified plans.
In Chapter 7, 401(k) loans are basically ignored. It’s my practice to show the payment as a payroll deduction on Schedule I, the debtor’s income schedule. I view it as an ongoing expense that the debtor will continue to repay. It’s also important for the U.S. Trustee’s office to have this information.
The real difference between how 401(k) loans are treated in Chapter 7 and Chapter 13 is in the means test. In Chapter 7, the means test’s purpose is to help the bankruptcy court determine “abuse.” That is, does the debtor have enough income to fund a Chapter 13 to some material extent? In most cases, that would mean that the debtor could pay at least $200 a month to unsecured creditors. Any less than this amount really doesn’t justify forcing the debtor–under penalty of dismissal–into a repayment plan. And in Chapter 13 the means test helps determine how much above-median income debtors must pay into their repayment plans.
Expenses are important
This means–pardon the pun–that counting all available expenses is important. More legitimate expenses result in less disposable income remaining to pay into a Chapter 13 plan. This is why bankruptcy filers should work hard at telling their lawyer about all of their expenses.
This is also where the 401(k) loan situation gets, well, weird. On the Chapter 7 means test 401(k) loans are not counted as an available expense (like food, auto ownership, and housing). However, on the Chapter 13 means test, which is used to determine how much unsecured creditors should receive, 401(k) loans are counted.
What does this mean?
Let’s say you took out a 401(k) loan a year prior to filing your bankruptcy. Maybe you used the money to live on during a period of unemployment or had to put a new roof on your house. You borrowed $19,000. At bankruptcy filing, you have $15,000 left to repay. Let’s further say that your payments are $250 a month.
Paradoxically, you could fail the Chapter 7 means test, yet show nothing available to repay unsecured creditors in Chapter 13. This is yet another absurdity in our current bankruptcy law.
The good news
The good news here, however, is for Chapter 13 filers. In Chapter 13, debtors are allowed to continue to repay their 401(k) loans in Chapter 13 and, more importantly, count those payments as expenses–like mortgage payments and food, for example.
For Chapter 7 cases, while 401(k) loan repayments can’t be counted on the means test, it’s still important to point out that 401(k) loans are being repaid. That tells the U.S. Trustee’s office they need to factor those payments into their “abuse” analysis when they review your case. After all, there’s no point in debtors being in a Chapter 13 plan if their creditors would receive only a nominal distribution–or even none at all.