Treatment of 401(k) accounts in bankruptcy

In these difficult economic times, many clients have contacted us regarding the treatment of their 401(k)s and 401(k) loan repayments in a chapter 7 bankruptcy filing. The first rule is that in bankruptcy, a 401(k) is exempt from a bankruptcy estate under § 282(2)(e) of the New York State Debtor and Creditor law and therefore creditors cannot attach the proceeds of a 401(k) account. Therefore, if it all possible, a debtor should not borrow from their 401(k) to pay creditors.

But if someone does borrow money from their 401(k), how do these loan repayments affect a personal bankruptcy filing?

1. In order to qualify for Chapter 7 personal bankruptcy, there are two tests that need to be met–the first is the "Disposable Income Test" and the second is the "Means Test".

2. The Disposable Income Test takes an individual's after-tax monthly income and subtracts their ordinary and necessary living and business expenses. If an individual has positive disposable income (or their after-tax income exceeds their living and business expenses), then they do not qualify for chapter 7 bankruptcy and must file for chapter 13 bankruptcy or not file at all.

The question is, are 401(k) loan repayments eligible to be a deduction for the disposable income test? In this jurisdiction (the Southern District of New York), the standard appears to be that if the 401(k) loan repayments are required by an employer or the entity that administers the 401(k) pension plan, those loans would be an allowed deductible expense.

3. Are 401(k) loan payments deductible for purposes of the means test? The answer appears to be no, based on several cases, including Egebjerg v. Anderson (In re Egebjerg), 574 F.3d 1045 (9th Cir. 2009) and In re Koch, 408 B.R. 539 (Bankr. S.D.Fla. 2009). In both of these cases, the courts concluded that 401(k) loan repayments do not qualify as a § 707(b)(2)(A)(ii)(I) other necessary expense-involuntary deductions (which is at line 26 of the form) for purposes of the means test.

Based on the above, it would be best for clients not to borrow against their 401(k) if they are contemplating filing for bankruptcy. Even if an individual borrows from a 401(k) plan, they may still be eligible to file for personal bankruptcy based on their overall income, expenses, assets and liabilities, although these calculations need to be done by an experienced bankruptcy attorney.

Anyone with questions regarding personal bankruptcy should contact Jim Shenwick.