How Bankruptcy Affects a 401K Loan

Bankruptcy Affects All Aspects of Your Life, Including the Money You’ve Saved over the Years.

This is especially true if you’ve used any retirement savings, including a loan from a 401(k) plan, to help you avoid filing for bankruptcy. Sometimes, the last-ditch attempts you make to avoid filing don’t work out and you’re left dealing with a more complicated filing situation than if you’d committed to filing months or years ago.

The good news is a bankruptcy attorney can help you sort through your situation and make the most of your bankruptcy opportunity.

What do you need to know if you borrowed against your 401(k) and you’re now filing for bankruptcy?

Bankruptcy and 401(k) Savings

First, it’s important to understand how bankruptcy affects a 401(k) savings plan in general.

As long as your 401(k) is ERISA qualified, it will be protected when you file for bankruptcy. For many people filing for bankruptcy, their 401(k) savings is their biggest asset, so this protection is great news.

Furthermore, it’s not just 401(k) plans that are protected, but nearly all employer-sponsored retirement savings plans.

Your bankruptcy attorney will review your retirement savings information and discuss with you what is protected and what isn’t, but in general, you can breathe a sigh of relief when it comes to the funds you’ve saved for retirement.

For more information about bankruptcy and your retirement savings, check out this article from The Balance.

What If You Borrowed Against a 401(k) Savings Plan?

It’s possible to take out a loan against your 401(k) savings and many people who are struggling financially and trying to avoid bankruptcy do so. It’s common for someone filing for bankruptcy to have questions about a 401(k) loan.

401(k) loans are not dischargeable in bankruptcy and are not considered regular debt. In a way, you are the creditor because you’re borrowing your own money. However, you still need to repay the loan once your bankruptcy is complete.

Furthermore, you cannot use any assets liquidated in a Chapter 7 bankruptcy to repay the loan against your 401(k), nor is the loan part of your repayment plan in Chapter 13. Most of the time you are still permitted to make automatic payments toward the loan during Chapter 13, but this is determined on a case by case basis.

Continuing to repay the loan during bankruptcy allows you to keep from falling behind on your end goals for retirement, even if your 401(k) loan repayment can’t be part of the overall Chapter 13 plan.

Should You Use a 401(k) Loan to Pay Off Debt?

So is it even a good idea to use a loan against your retirement savings to pay off debt?

Probably not. Especially not if it won’t completely eliminate all of your debt.

The primary reason for this is because any money taken from your retirement savings is no longer eligible for protection under bankruptcy. The money can also be used against you when it comes to the bankruptcy MEANS test. It’s possible someone who qualified for Chapter 7 debt discharge would be unqualified based on the money borrowed from their 401(k).

It’s also important to remember that if you borrowed against your retirement savings and chose to pay off the loan right before filing for bankruptcy, your trustee could undo the transfer and use that money to pay other creditors. Repaying the loan is essentially repaying yourself and some trustees are going to view that as a lower priority debt than your other creditors.

The key to a successful bankruptcy is to understand your options and be informed enough to make the best choice based on your circumstances. The last thing you want to do is misuse your retirement savings and create lifelong problems for yourself financially.

If you have questions about your 401(k) and bankruptcy, or you have a 401(k) loan and you aren’t sure how it will be affected by bankruptcy, we can help. Contact the Law Office of Robert M. Geller at 813.254.5696 to schedule a consultation.