401(k) Loans in Chapter 13: The Step‑Up Trap That Can Break Your Plan

For many consumers, a 401(k) loan feels like the perfect financial lifeline, especially since you get to skip the bank, applications, and credit scores, since you are essentially borrowing from yourself. However, once you file Chapter 13 bankruptcy, your retirement loan could affect your plan payments.

By Alexander Hernandez, J.D., Professor, and Author of Consumer Bankruptcy Law (Routledge).

Key Takeaways on 401(k) Loans and Chapter 13 Bankruptcy

• Payroll Deductions: 401(k) loans lower your disposable income, which can help you qualify for Chapter 13, but the Trustee could object.
• The Step-Up Plan: Once the loan is paid off, the money usually goes to your creditors, not your pocket.
• Bad Faith Risks: Avoid taking out new 401(k) loans immediately before a bankruptcy filing. Those funds could be considered non-exempt and subject to seizure by the Trustee, or counted as income, increasing your plan payments.
• Conversion Plan: If the step-up makes your plan unfeasible, a Chapter 7 conversion may be the necessary “Plan B.”

Secured Retirement Debt and Bankruptcy

When filing for bankruptcy, the first step is the Means Test, which calculates your average income for the six months before filing. A substantial withdrawal within those six months could result in pushing you from Chapter 7 to 13.

A 401(k) loan is unique because it is categorized as secured debt, so as long as there aren’t any objections by the trustee, it reduces your disposable income. However, once the loan is paid back, the trustee considers your increase in disposable income as a way to pay back more to unsecured creditors.

The “Step-Up” Provision in Chapter 13

Logic suggests that once the loan is gone, your monthly expenses drop, and you should have more money in your pocket. In bankruptcy, the opposite is true. Most Trustees include a “step-up” provision in the plan.

Once that secured 401(k) payment is finished, that exact amount of money is immediately redirected to your unsecured creditors, such as credit cards, medical bills, and personal loans.

The Timing of a 401K Withdrawal

One area where I often see clients get into trouble is the “Pre-Filing Loan.” If a debtor takes out a massive 401(k) loan just weeks before filing for bankruptcy, the Trustee may view this as an attempt to “game” the system by artificially lowering disposable income. This can lead to an objection based on Bad Faith.

In addition, if the funds have been moved from an exempt account to a regular account, it loses its protection, meaning the trustee will have access to seize those funds or require that amount to be paid back.

For example, suppose there is a $10,000 401(k) withdrawal and those funds were deposited into a regular checking account. From that withdrawal, $2,000 was used to retain the bankruptcy lawyer, leaving $8,000 in the account.

Depending on your state’s exemptions, part, if not all, of the remaining funds may not be protected. That $8,000 could be seized by the trustee to pay back creditors, or require that the amount be paid back through the plan.

Voluntary Contributions vs. Creditor Rights

There is a significant split between Bankruptcy Districts on how voluntary contributions are treated.  

• Some courts argue that you should not be “saving for yourself” while your creditors are receiving less than 100% of what they are owed.
• Other courts allow reasonable contributions to continue.

Knowing which side of the fence your local court sits on is the difference between retiring with a nest egg or not contributing to your retirement for three to five years.

Strategic Takeaway: The “Big Lots” Comparison

We recently saw this in the corporate world with the Big Lots Chapter 11 failure. Just as a major retailer might find that its “reorganization” math no longer adds up when costs rise, an individual might find that the “step-up” in payments after a 401(k) loan is satisfied makes their Chapter 13 plan unsustainable.

If your budget can no longer handle the plan once those funds are redirected to unsecured creditors, you could consider converting from Chapter 13 to Chapter 7. However, to do so, you must satisfy the “Liquidation Test.”

The Liquidation Test is based on a hypothetical Chapter 7 case and, in part, determines how much unsecured creditors receive in a Chapter 13. For example, suppose you were filing Chapter 7, and based on non-exempt assets, you had to pay back $5,000. With Chapter 13, that is the amount that unsecured creditors would receive, in addition to disposable income.

Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. Paralegals and students who are buying single copies can do so via Amazon Books. To access my YouTube channel, click this link.

You can learn more about filing for bankruptcy and the bankruptcy petition via this link. Information on the bankruptcy court system, contact information for trustees, and your state’s exemptions can be found here. The federal bankruptcy exemptions are listed here. The latest version of the 341 Meeting of the Creditors can be found here.

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