November 20, 2017

The Problem with 401(k) Loans and Consumer Bankruptcy

Most of the clients who I represent in Chapter 7 or Chapter 13 cases view bankruptcy as their absolute last resort.  Usually, by the time they get to me, these clients have exhausted every other alternative – they have borrowed money from relatives and friends, sold possessions on eBay and cashed out or borrowed against retirement plans.

All of these choices, by the way, create unintended consequences – if you are reaching that point of desperation where you are thinking about selling things, cashing out retirement plans, etc., I would rather that you call me  before taking any action because of the risk that you might unknowingly lose some of the benefit from your bankruptcy filing, or possibly disqualify yourself altogether.

Retirement plan loans such as 401(k) loans create a variety of issues and are almost always a bad idea in a bankruptcy context.   Presumably you borrow against your 401(k) because you need cash now, you expect to repay that loan in the near term, you want to preserve your 401(k) account for the future, and because you do not want the tax consequences associated with cashing out your 401(k).

Bankruptcy trustees, however, look at 401(k) loans in a different light.   They see any allocation to repay a 401(k) loan (and sometimes any ongoing contribution to a 401(k) plan) as an unnecessary reduction of disposable income that would otherwise be available to pay creditors.    401(k) loan payments cannot be counted as allowable deductions in your means test calculations.   And both Chapter 7 and Chapter 13 trustees and/or creditors will often object if you include a 401(k) loan repayment allocation in your Schedule I and J budget in either a Chapter 7 or Chapter 13. [Read more…]

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