How Long After Filing for Bankruptcy Can I Take Out a 401k Loan?

If you have filed for bankruptcy, when you can take out a loan from your 401k retirement fund depends on whether you filed for Chapter 7 or Chapter 13 bankruptcy.

By , Attorney · University of the Pacific McGeorge School of Law

You can take out a 401k loan after you file for Chapter 7 bankruptcy without risk of losing the money to the Chapter 7 bankruptcy trustee assigned to your case, although it would be prudent to wait until after your case ends. By contrast, in Chapter 13, you're prohibited from borrowing against your 401k without first getting permission from the bankruptcy judge.

If you're thinking that you'd prefer to borrow against your 401k loan before filing for Chapter 7 or Chapter 13, keep in mind that it can be risky—especially if you don't use the funds beforehand for a necessary expenditure and instead, deposit the money in a bank account.

ERISA-Qualified 401k Plans Are Safe From Creditors in Bankruptcy

One of the great things about contributing to an ERISA-qualified 401k is that as long as the money remains in the account, it's safe from creditors, regardless of whether you file for bankruptcy. In bankruptcy, ERISA-qualified 401k plans aren't property of the bankruptcy estate, so the Chapter 7 bankruptcy trustee can't seize the fund to pay your debts, and you also won't have to pay an equivalent amount through a Chapter 13 repayment plan.

Helpful Tip. In almost every instance, taking out a loan from your ERISA-qualified 401k plan to pay off debts that are dischargeable in bankruptcy, like credit card balances, medical bills, overdue utility payments, and personal loans is ill-advised. Why? In many cases, filing for bankruptcy is inevitable, and using funds that you can protect in bankruptcy to pay debts you can wipe out would be akin to throwing money down the drain. Keep your future bright by erasing burdensome debt while maintaining a secure retirement plan.

What Happens If You Take Out a 401k Loan After Filing for Bankruptcy?

Your ERISA-Qualified 401k funds are safe from creditors only while the money remains in the 401k account. Once withdrawn through the loan process, the money loses its protected status and becomes ordinary cash. Here are some of the basics you'll want to know about taking out a 401k loan after filing for bankruptcy.

Chapter 7 Bankruptcy

Nothing is stopping you from taking out a loan on your 401k after filing a Chapter 7 case, and there should be no recourse. With a few exceptions, the trustee can take only assets—cash in this case—that you owned on the date of the bankruptcy filing. Anything you acquire after filing for bankruptcy is yours to keep.

Even so, strange things happen in bankruptcy cases, so the prudent course of action would be to wait until you receive your discharge—the order that wipes out your debts—and your case is closed before taking out a 401k loan. This safeguard should protect you against any unforeseen complications and prevent tracing issues if you inadvertently commingle the funds with nonexempt money.

Chapter 13 Bankruptcy

If you want to take out a 401k loan during Chapter 13 bankruptcy, you'll need to obtain court permission first because the loan payment will be a new expense. Chapter 13 filers agree to repay all of their discretionary income to creditors in their three- to five-year repayment plan, so all of the available income should already be utilized, leaving nothing for the new loan payment.

But sometimes circumstances warrant taking out a loan, such as when an unexpected yet justified expense crops up. You'll need to file a motion explaining the particular circumstances of your case. The bankruptcy judge will review the facts, including whether it's feasible to pay your nonpriority unsecured debts less—the creditors who fall lowest in payment priority—before approving or denying the loan request. If you aren't paying anything to these creditors, it's unlikely that the court would approve the loan.

What Happens If You Take Out a 401k Loan Before Filing for Bankruptcy?

Once you take funds out of your 401k, the money is no longer protected from creditors. It's classified as ordinary cash or funds in a bank account.

Use 401k Loan Proceeds Wisely Before Filing for Bankruptcy

If you intend to use all of the funds before filing for bankruptcy, you likely won't be at risk of losing any money in your bankruptcy case if you plan ahead. For instance, you can use the funds for a necessary purpose, such as replacing a broken HVAC unit or repairing the car you use for work, errands, and taking the kids to school.

If you purchase something with the funds, be sure that you can protect the asset with a bankruptcy exemption. You'll run into trouble if you use the funds to buy a nonexempt luxury item, such as a noncommercial boat or expensive recreational vehicle. You'll either lose the new purchase in Chapter 7 or have to pay an amount equivalent to its value in Chapter 13. It's a good practice to consult with a local bankruptcy attorney about the types of expenditures your local bankruptcy court finds acceptable.

Don't Count on Protecting Cash and Bank Balances in Bankruptcy

If your 401k loan funds are sitting in a bank account, you probably won't want to file for bankruptcy. Once out of the 401k account, you must protect the funds the way you would any money in a bank account—with a bankruptcy exemption.

Here's the problem. Most states don't protect much in the way of cash or a bank account balance, and some don't protect any at all. And don't expect the bankruptcy trustee to sympathize with you and let you keep the funds. Cash or money in the bank is an easy asset to value and seize. Plus, trustees receive a percentage of the funds paid out to creditors, which provides the trustee with even more incentive to snatch up these "low hanging fruit" assets.

Another option would be using a wildcard exemption—an exemption you can use for any asset of your choosing, although some states limit wildcard use to certain property. But again, wildcard exemption amounts vary significantly between states, and some don't offer a wildcard at all. Finally, the federal bankruptcy exemptions include a reasonably substantial wildcard exemption. Still, you'd have to live in one of the handfuls of states that allow a filer to use the federal exemptions in place of the state exemptions to use this approach.

Other 401k Loan Considerations

While a 401k loan can be an easy and convenient way to obtain money, it also has drawbacks. When you take out a 401k loan, that money no longer earns a return, other than the percentage you pay yourself over time. Also, not paying back your loan can result in hefty penalties and adverse tax consequences. Consider talking to a financial advisor and evaluating other alternatives before borrowing against your 401k.

Meet With a Bankruptcy Lawyer

No one wants to lose property in bankruptcy, but it can happen—especially in Chapter 7. Chapter 7 debtors don't have the right to dismiss the case when the trustee wants to take property without first getting permission from the court. So it's essential to know how to protect cash and bank accounts in bankruptcy if that's the way you choose to go, as well as any other property before filing your action. Ultimately, the most prudent course of action is to consult with a knowledgeable bankruptcy lawyer.

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