First, just to be clear, a 401[k] loan is not actually a “loan” in the traditional sense. It’s really just a way of accessing some of your retirement money early without paying a tax penalty. Because it’s not a real loan, with a real creditor on the other side of the transaction, a bankruptcy debtor isn’t released from his obligation.
That doesn’t mean, though, that 401[k] loans aren’t helpful in a bankruptcy case. In chapter 13 cases, the money a bankruptcy debtor pays to his 401[k] account reduces the amount of disposable income certain debtors are required to pay to their creditors. Money paid back on a 401[k] loan isn’t exactly money in the pocket, but it is money a debtor will see again eventually. It’s certainly better than that money being paid to a debtor’s creditors.
But many chapter 13 cases are designed to last five years. What happens if a 401[k] loan is paid back before the five year plan is completed? The 6th Circuit court of appeals recently ruled that the money that had been going to toward the repayment of the 401[k] loan must be redirected to a debtor’s unsecured creditors. In other words, if a debtor is paying $250 each month to his 401[k] loan, once that loan is paid back, the debtor must add $250 to his chapter 13 payment. At least according to the 6th circuit. Fortunately, the 4th circuit (where we are) has not made a similar ruling, yet.
A small caveat: the scenario described above would affect only those debtors who are already required because of their relatively high income to make some payment to their unsecured creditors. Most debtors in chapter 13 simply do not earn enough money (with or without 401[k] contributions) for the court to require these payments to unsecured creditors to be made.