Can I Continue Retirement Contributions During Bankruptcy?

If you’re wondering whether you can continue to make contributions while you’re going through the bankruptcy process read on to find out if you can. Bankruptcy courts, including appellate courts, are split whether a debtor may continue payroll deductions to fund a voluntary retirement account, such as a 401(k), during a Chapter 13 case.

The issue boils down to two competing interests: savings for the debtor’s retirement versus additional payments to unsecured creditors during the bankruptcy case. In attorney jargon, are wages earmarked for retirement contributions considered “disposable income?”

Three competing interpretations have developed. First, some courts find that voluntary retirement contributions are not disposable income, so debtors can continue to make them during a Chapter 13 plan period.

This is the majority view. Courts adopting this view permit debtors to make voluntary contributions during a Chapter 13 case, even if no contributions were made before bankruptcy. See In re Johnson, 346 BR. 256 (Bankr. S.D. Ga. 2006).

Second, a minority of courts take the opposing view, that voluntary retirement contributions are disposable income and this money should instead be paid to creditors while a Chapter 13 plan is in effect. Finally, a few courts “split the baby”: a debtor may continue to contribute to retirement at the same rate as before filing bankruptcy. The debtor may not increase retirement contributions or commence payments for the first time.

One recent case that sided with the minority view is the case of In re Parks, 475 B.R. 703 (BAP 9th Cir. 2012), which ruled that voluntary 401(k) contributions are not allowed deductions in the Chapter 13 Means Test. However, during an appeal to the Ninth Circuit the case was dismissed after a stipulation was filed (meaning there is not a 9th Circuit opinion on the matter).

If your circuit and bankruptcy court allows you to continue contributions to your retirement account, you can use these contributions to qualify for Chapter 7 or reduce your projected disposable income (and reduce your monthly plan payment to unsecured creditors).

Obviously, in jurisdictions that follow the Johnson majority rule, a Chapter 13 debtor may benefit from contributing to a voluntary retirement account rather than see his earnings sent to pay trustee fees and unsecured creditors. In cases filed in Solomonic courts, the debtor may wish to postpone bankruptcy to establish a pattern of 401k contributions prior to bankruptcy.

While courts are split on the issue of continued retirement contributions, they are agreed on the matter of retirement loan repayment during Chapter 13 bankruptcy. See In re Bruce, 484 B.R. 387 (Bankr. W.D.WA, 2012) (source).

In Bruce, the debtor argued that Section 541 of the Bankruptcy Code required that the 401(k) contributions made in the six months prior to the filing of the case be excluded from his income for purposes of section 1325(b)(2), and the court agreed. This meant that the ongoing 401(k) contributions to repay a loan would be allowed (disagreeing with Parks). The court also held that Bruce’s Chapter 13 payment would not have to increase when his 401(k) loan repayment was finished.

A sizeable repayment for a 401(k) loan may make the difference between lowering the monthly payment to unsecured creditors. A viable pre-bankruptcy strategy is for the debtor to take out a loan from a 401(k) – if at a favorable interest rate – just prior to filing to minimize amounts paid to unsecured creditors. The debtor can then convert the loan cash into an exempt asset, even into a protected retirement vehicle like an IRA.

Consequently, even in Circuits that do not allow the debtor to continue contributions to retirement funds during a Chapter 13 bankruptcy, the debtor can create his own permission by taking out a pre-bankruptcy loan against his 401k.

In most jurisdictions, during a bankruptcy case a debtor may contribute to a retirement account and repay a loan against that account. Of course, it would be completely foolish for any individual to move funds from an exempt and protected retirement account without first consulting with experienced bankruptcy counsel. It is equally imprudent for a debtor to take loans or commit new retirement payments on the eve of bankruptcy without legal assistance.

Strategic bankruptcy planning is expected and encouraged by Congress and the United States Supreme Court, so the wise advice is to consider all options and receive legal advice prior to filing a bankruptcy case.