Can You File Bankruptcy on a 401K Loan?

Types of Bankruptcy

• There are two main types of bankruptcy declared by individual consumers. In a Chapter 13 filing, the court assesses the income and assets of the consumer and implements a plan for him to pay a portion of his debt. A Chapter 13 allows creditors to recover some of what they are owed, while the debtor maintains possession of important assets, such as a home, automobiles or similar belongings. Chapter 7 is declared when the debtor possesses no significant assets and has no hope of paying her creditors. In this kind of filing, the vast majority of the debt is simply discharged, or legally erased without being paid.
  
  

401k Loans

• Some debtors, to survive a crisis in their financial situation, borrow against their retirement accounts. Because the funds in a 401k account belong to the borrower, these loans are seldom declined and the interest rates are low. If the borrower is unable to repay the loan, he will owe taxes and penalties on the withdrawal but will face no collections or legal action.
  
  

401k Loan Defaults

• The money contributed to a 401k belongs to you. While it remained inside the 401k account or as a loan in good standing, it received preferential tax treatment. If the loan defaults, you owe penalties and taxes. But, not being able to repay the principal leaves you in debt only to yourself. As such, it need not (and cannot) be restructured or discharged via bankruptcy.
  
  

Disadvantages of 401k Loans

• That said, being unable to repay a 401k loan can leave your retirement underfunded. Because of the low interest rates and typical performance of the investments in which 401k funds participate, frequent or large 401k loans can damage your retirement income even if they do not default.
  
  

Bankruptcy Treatment of 401k Loans

• 401k loans are ill-advised if you face bankruptcy. If you can't repay the loan, penalties and taxes can be burdensome. The withdrawal is also counted as an asset that might be seized in the bankruptcy. On the other hand, if the loan is repaid, the court will regard the payments as simply being a transfer of funds from yourself to yourself, which could render you ineligible for bankruptcy. The third option, leaving the funds in the retirement plan, will not damage your retirement income, and bankruptcy courts do not regard retirement funds in their means tests or seize them as assets to be paid to creditors.