Most people who are experiencing financial difficulties have tapped into their retirement plans to try to catch up on mortgage payments, medical bills or credit card debt. Borrowing against your 401K retirement, will require that you pay the amount back over a period of time in order to avoid penalties. What happens when you have to file for bankruptcy and have a 401K loan?
401K loans have generally not been treated as a debt for bankruptcy purposes. Since it is money that you are paying back to your retirement, it is not considered a debt. If you fail to pay this debt through a 401K loan repayment then you will have to incur the penalties involved in the early withdraw of money from your retirement.
How Will the 401K Loan Repayment Be Treated in A Chapter 7 Bankruptcy ?
Most courts have rules that a 401K loan repayment is not a necessary expense or a debt that can be deducted from your monthly disposable income. You cannot deduct your 401K loans on the means test in order to qualify for a Chapter 7 bankruptcy. If you have disposable income after deducting reasonable monthly expenses such as food, rent, clothing, then you may need to file for Chapter 13 bankruptcy. Even if your additional monthly income is going toward paying off your 401K , this amount will be treated as disposable income in a Chapter 7 bankruptcy.
How Will the 401K Loan Repayment Be Treated in A Chapter 13 Bankruptcy ?
If you are filing for Chapter 13 bankruptcy you can deduct the monthly amount that you are contributing toward paying your 401K. You can continue to repay the money borrowed from your 401K while you are in Chapter 13 bankruptcy. The remainder of your disposable income after covering your reasonable necessities and 401K loan payments, will be used to pay creditors.
It sounds contradictory to be able to deduct a 401K repayment in a Chapter 13 bankruptcy while not being able to deduct it to qualify for a Chapter 7 bankruptcy. Unfortunately the bankruptcy laws don't always make sense. Hopefully in the future courts will rule that paying back a 401K loan is a necessity for purposes of a Chapter 7 bankruptcy. After all retirement income is a necessity for the majority of people when they retire.