Before providing an answer to the issue on the treatment of 401k loans in a bankruptcy, it would be best to define bankruptcy and 401k loans. It would also be a great time to inform you that the best education and advice you can receive is from a licensed and experienced attorney in your state. I must disclose that I am not a lawyer and most of this information is easily obtainable on the internet.
For individual bankruptcy, the applicable laws are Chapter 7 and Chapter 13.
In Chapter 7, the non-exempt property of the debtor will be liquidated and the proceeds will be given to the unsecured creditors. However, it is often the case that the debtor who goes into bankruptcy will only have exemptÂ property, such as an older car, household goods, and clothing. In return, some of the debts will be forgiven but some kinds of debt would not be included, such as some taxes, student loans, and support for spouse and children.
In Chapter 13 bankruptcy, the debtor will not be required to surrender any property but agrees to set aside a part of his or her income in the future for the repayment of the loans. No debt is forgiven in a Chapter 13 bankruptcy.
Hence, the question on the treatment of 401k loans in a bankruptcy is focused on Chapter 7 bankruptcy because it is here that debt is discharged or forgiven. But let us first look into the nature of 401k loans before we can answer the question
A 401k is an employer sponsored retirement plan and is generally exempt from bankruptcy. If you have a 401k loan, you have actually borrowed against your own 401k retirement account. This kind of loan is quite popular because it is easy to get, there is no need for a credit check and the interest rate is low. Filling out an application is easy and if you look at it, the interest you would be paying for the loan would actually go to yourself.
The reason there is no need for a credit check is because you are actually borrowing your own money. However, what this means is that 401k loans are not considered to be real loans and are not affected by bankruptcy, except with regards to the possible restructuring of the payment of the penalties incurred for non-repayment and the tax charges.
When you are unable to repay a 401k loan as per schedule, it will be automatically seen as a withdrawal from your retirement account and you will be taxed accordingly and you will be charged an additional 10 percent of the unpaid amount as penalty if you are less than 59 Â½ years of age.
Therefore, if you are considering bankruptcy, unpaid 401k loans may be difficult problems because they are not seen as debts and cannot be forgiven. However, the monthly payments may be exempted from the means test computations for disposable income in bankruptcy.
This computation is employed to determine if your income is sufficiently low to qualify you for a Chapter 7 bankruptcy. What this means is that the unpaid monthly amounts for your 401k loan that are considered for tax purposes as your income need not be included when calculating your disposable income to test whether you can file for Chapter 7. If your income is less than the median income for your state, then you are automatically qualified to file for Chapter 7.