Consumers considering bankruptcy usually do so only as a last resort. If you are in this situation, you have likely exhausted all other options to keep yourself financially afloat, from selling off possessions to cashing out or borrowing against retirement accounts. If you have borrowed – or are considering borrowing – from your 401(k), 403(b), 457 or other qualified retirement plan, keep in mind that these loan repayments receive very different treatment, depending on whether you are filing for Chapter 7 or Chapter 13 bankruptcy, and can negatively impact your ability to qualify for a Chapter 7 discharge. If bankruptcy may be in your future, you should consult with an attorney before borrowing against any retirement accounts to avoid unintended consequences.
Most who borrow against their 401(k) accounts do so because they need access to immediate cash and intend to repay the loan in the short term in order to preserve the funds for retirement and avoid the income tax ramifications of an early distribution. Unfortunately, bankruptcy trustees don’t see it the same way. In the trustees’ view, allocations for repayment of 401(k) loans result in an unnecessary reduction in disposable income that you would otherwise use to repay your creditors under a Chapter 13 plan.
The primary difference in how these retirement account loans are treated in Chapter 7 versus Chapter 13 bankruptcy is in the “means test.” To qualify for a Chapter 7 bankruptcy, you must meet one of two conditions: 1) your household income is below the average income for your family size in your state; or 2) if your household income is greater than the average, but you pass the means test. In Chapter 7, the means test is used to help the court determine whether the debtor has enough income to fund a repayment plan under Chapter 13, rather than seeking a discharge under Chapter 7.
The means test establishes a budget using “reasonable” figures as determined by the IRS. If your actual expense exceeds the “reasonable” figure, any excess is deemed to be disposable income available to repay unsecured creditors. Unfortunately for 401(k) borrowers, these loan repayments cannot be included in their Chapter 7 means test budget. As a result, under the means test calculation, any amount you are repaying to your 401(k) loan is actually deemed to be “available” to repay creditors under a Chapter 13 repayment plan. The trustees are concerned with making sure your creditors are paid, if at all possible, and are not concerned as to whether your failure to repay your 401(k) loan will cause you to owe income taxes or penalties.
Under a Chapter 13 bankruptcy means test, however, 401(k) loan repayments are included as an allowable expense. The Chapter 13 means test is used to determine how much money should be paid to unsecured creditors as part of your repayment plan. By including the loan repayments as an expense under the Chapter 13 means test, the amount of disposable income leftover to repay your unsecured creditors is reduced.
As you can see, with so many nuances and distinctions between the bankruptcy remedies available, it is vitally important that you share with your attorney all available information about every asset or debt – even when you just owe the money to “yourself”.