Should I pay off creditors with a 401k loan prior to bankruptcy?

Question

I am considering filing for bankruptcy. However, I have funds in my 401k account. Should I take out a 401k loan to pay off some creditors before filing for bankruptcy?

Answer

Although it can be tempting to borrow from your 401k or another protected retirement account to pay off creditors, it’s generally a bad idea. Here’s why.

You Can Wipe Out Debt and Keep Your Retirement Funds

People are living longer these days, so it’s safe to assume that as you approach retirement, you’ll want to minimize your debt while keeping as much in your retirement account as possible. Filing for bankruptcy can help you accomplish both goals.

Here’s how it works.

• Discharge debt. Most filers choose either Chapter 7 or Chapter 13 bankruptcy to take care of financial problems. A Chapter 7 bankruptcy takes about three to four months to wipe out qualifying debt. If you file a Chapter 13 bankruptcy, you pay your creditors through a three- to five-year repayment plan. All of your debt, other than longterm loans, such as a mortgage or student loan, will be gone once you complete the plan.
• Protect retirement funds. The point of filing for bankruptcy is to give you a fresh start, so you’re able to keep—or exempt—the things you’ll need to work and live. Most retirement accounts are exempt and protected in bankruptcy (although balance caps apply). The bankruptcy trustee can’t take the money to repay creditors. You’ll look to your state exemption laws to find out about the other things you’ll be able to keep.

Your particular financial situation will determine whether a Chapter 7 or Chapter 13 case is best for you.

A 401k Loan Will Survive Bankruptcy

Keep in mind that if you file a bankruptcy case, you’ll still be responsible for repaying the retirement account loan according to the retirement plan’s rules. The payment might leave you without the necessary funds to meet your household expenses or to continue saving towards retirement.

Moreover, if you are less than 59½ years old and you leave your job before you have repaid the loan, you’ll need to pay it off quickly. Otherwise, you could get hit with income taxes on that money, plus an early withdrawal penalty.

Paying Debts Can Complicate Your Bankruptcy

Bankruptcy protects creditors by ensuring that they receive what they’re entitled to be paid. You can’t get around these rules by paying certain creditors with a 401k loan before your bankruptcy.

If you pay off some creditors before bankruptcy, but not all (called a preferential transfer) the bankruptcy trustee might be able to get the money back (avoid the transfer), depending on the payment amount, the creditor, and when you made the payment.

Here are the rules on preferential transfers:

If most of your debts are consumer debts (nonbusiness debts), the bankruptcy trustee can void the transfer or payment and attempt to get the money back if:

• you made a payment of $600 or more to a single creditor within 90 days before you filed bankruptcy ($6,425 if the majority of your debts are business in nature), or
• you paid a family member, friend or business associate, any amount within one year of your bankruptcy filing.

For more things to consider before filing for bankruptcy, see Prebankruptcy Filing Considerations.