Filing for bankruptcy can be problematic for debtors that have taken out loans against a 401K or other retirement account. Loan repayments to a 401K plan do not qualify as a living expense when one files for bankruptcy, and therefore, hurt a debtor’s chance of qualifying for bankruptcy protection under Chapter 7. A loan repayment to a retirement plan is effectively a loan from oneself, the court may rule that other creditors take precedence over repayment to the 401K.
Chapter 7 Bankruptcy - The Means Test
Qualifying for Chapter 7 bankruptcy requires that a debtor fill out Form B22A, the Statement of Current Monthly Income and Means Test Calculation. This form, known as the “Means Test” is the primary tool to determine eligibility for Chapter 7 bankruptcy. The Means Test determines whether disposable income is sufficient to meet financial obligations. The Means Test does not include a calculation of a loan repayment as a debt. Therefore, if a large portion of a debtor's income is going toward repaying a 401K loan, this may hurt her ability to qualify for Chapter 7 bankruptcy.
Chapter 13 Bankruptcy - Tax Implications
When a loan is taken against a 401K, a repayment plan is set up to avoid the tax penalties associated with early withdrawal. Early withdrawal occurs when the owner of the 401K account withdraws the money prior to the mandatory retirement age. Because contributions to a retirement account are tax-free, the money is taxed at retirement age, when the money is needed. If the money is withdrawn early, the money is both taxed and penalized.
Filing for Chapter 13 bankruptcy may require the debtor to discontinue payments to a 401K repayment plan, thereby incurring tax penalties associated with early withdrawal.
Courts Are Still Undecided
Recent cases since the bankruptcy law of 2005 show that some courts allow repayments to a 401K loan plan under Chapter 13 so that the debtor can avoid the severe penalties associated with discontinuing these payments. Some courts believe that the incentive for responsible financial behavior carries a higher priority than using this money to pay back creditors.
Taking a loan against a 401K can be a risky endeavor. Indeed, many bankruptcy experts would recommend filing for bankruptcy before borrowing against a retirement account because the consequences can be devastating.
If you are considering bankruptcy, contact a qualified attorney in your state. An attorney specializing in personal bankruptcy can assist in choosing the best option for your situation.