Question

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

Answer

If you are considering bankruptcy, you probably feel overwhelmed by creditors who are demanding payment. Although it may be tempting to borrow from your 401k or other retirement account in order to pay off certain creditors, this is generally a bad idea. Here’s why.

Your Retirement Account Is Protected From Creditors

Generally, in a Chapter 7 or Chapter 13 bankruptcy case, your retirement account is a protected asset. This is because most retirement accounts are "exempt" in bankruptcy -- which means the bankruptcy trustee cannot take the money to repay creditors. In addition, even if you don't file for bankruptcy, most retirement accounts are exempt from collection by creditors. (For more on retirement accounts as exempt property, see Your Retirement Account in Bankruptcy.)

Borrowing From Your 401k Can Endanger Your Fresh Start

If you file a bankruptcy case, you are still responsible for repaying the retirement account loan according to the retirement plan’s rules. This may 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 will need to pay it off quickly, or you could get hit with income taxes on that money, plus an early withdrawal penalty.

At the end of a Chapter 7 bankruptcy, the court discharges (eliminates) your debt. (Learn more about the bankruptcy discharge.) If you borrow from your 401k accunt in order to pay off creditors and then file a Chapter 7 bankruptcy, you will be stuck repaying that 401k loan even if you could have otherwise discharged the underlying debts in bankruptcy. That means you'll end up repaying those debts long after your bankruptcy discharge.

If you file a Chapter 13 bankruptcy, you pay your creditors through a court-supervised repayment plan. During a Chapter 13 case, you are still responsible for repaying the 401k loan in addition to the plan payment. That can further strain your finances and make it difficult for you to afford the Chapter 13 plan payment and complete your case.

Paying Off Your Creditors Prior to Bankruptcy May Complicate Your Case

You are not allowed to "prefer" one creditor over another in bankruptcy -- and that extends to a certain time period before you file. If you do prefer one creditor over another by paying it off shortly before bankruptcy, the bankruptcy trustee may be able to avoid the transfer (get the the money back). Whether the trustee can get the money back depends on the payment amount, identity of the creditor, and when you made the payment. Here are the rules on preferential transfers:

If you pay off a debt totaling more than $600 prior to filing a bankruptcy, the bankruptcy trustee may void the transfer or payment and attempt to get the money back if:

• you made the payment within 90 days before you filed bankruptcy, or
• if the recipient was a family member, friend or business associate, you made the payment within one year of your bankruptcy filing.

If you feel strongly about repaying a relative or friend and you know that you will be filing a bankruptcy case, consult an attorney to discuss your options. To learn more about your options, see The Bankruptcy Trustee and Preferences.

For more articles on things you should and should not do prior to bankruptcy, visit our Prebankruptcy Filing Considerations topic area.

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