How 401(k) loans are treated in bankruptcy
Image via Unsplash
When planning for your future, a 401(k) account helps you plan for your golden years. Many employers provide 401(k) investment opportunities for their employees – and offer a match that can help you set aside even more for your golden years. That account is an asset, and you might not know this, but you can borrow against it. If you file Greensboro bankruptcy, you should carefully consider the fate of your 401(k) and any applicable loans.
How 401(k) loans work
When you invest in your 401(k), it comes out of your paycheck on a tax-free basis. That means your taxable income drops by the amount that goes into the account. Currently, the most you can invest in your 401(k) annually is $18,500, but if you’re over 50, you can add another $6k onto that. If you get into a cash crunch, you can borrow against what you’ve saved. In essence, a 401(k) loan is borrowing from yourself.
Borrowing against your 401(k) can be a help for a short-term cash crunch like replacing a major appliance that died or making an emergency car repair.
Advantages of 401(k) loans:
- It’s easy to apply
- Your credit score doesn’t matter
- Interest rates are low
- Interest is paid to yourself
- You get funds fast
Loans cap at the lesser of $50,000 and half your 401(k) balance. The loan term is usually five years, and you can repay from payroll deductions. Depending on the loan terms, you might not be able to contribute to your retirement fund while your loan is in repayment.
Borrowing from your 401(k) account isn’t all hearts and flowers, though. The risk comes if you cannot pay back the loan because there can be tough financial consequences.
Downsides of 401(k) loans:
- If you can’t repay, you’ll be penalty taxed as if it was an early withdrawal
- If you change jobs, the loan becomes due in full within 60 days
- You lose out on investment potential on the funds you borrowed
- Loan repayments are made with after-tax funds
Bankruptcy and 401(k)
When your debts stack up to the point that you need an intervention like bankruptcy, it’s important to know you can protect your assets. Retirement accounts including 401(k) and Roth IRAs are fully exempted in bankruptcy (unless you inherited the Roth IRA). Whether you choose Chapter 7 or Chapter 13 for your Greensboro bankruptcy, your retirement funds can’t be touched by the Trustee or your creditors.
In bankruptcy, secured and unsecured debt is treated differently under the law. Unsecured debt can be diminished or fully discharged depending on the chapter. Delinquent secured debts aren't cured by Chapter 7 bankruptcy, but you can catch up on them in Chapter 13. 401(k) loans are a different situation and cannot be diminished or discharged.
In Chapter 13 bankruptcy, you can continue paying on your 401(k) loan as if it was one of your standard expenses and under your three to five-year repayment plan, you should be able to complete the loan in good standing. If you can repay your loan under the required schedule, you should be okay.
However, if you can’t afford the loan, you’ll have to deal with the consequences listed above. Not only will you face steep tax consequences, but money not repaid on the loan is money lost from your retirement and golden years forever.
Weigh the potential outcome carefully before you tap your 401(k) with a loan. Consider all your alternatives and be sure that a 401(k) loan fits your finances and what you’ll do if you can’t afford to pay back the loan before you borrow!
To find out more about the life-changing benefits of bankruptcy, contact the Law Offices of John T. Orcutt. Read reviews from clients, then call +1-919-646-2654 for a free Greensboro bankruptcy consultation at one of our locations in Raleigh, Durham, Fayetteville, Wilson, Greensboro, Garner or Wilmington.