Bankruptcy Court Allows 401(k) Plan Loan Repayments Deducted from Income

October 16, 2006 ( - The US Bankruptcy Court for the Northern District of Ohio has ruled that a debtor's payment to repay a 401(k) loan does not qualify as disposable income in determining whether the debtor's filing for relief is considered abuse.

Rejecting a bankruptcy trustee’s motion, the court said that Gregory Thompson had demonstrated “special circumstances” that would exempt his 401(k) loan repayments from the calculation of his monthly disposable income for the purposes of filing for Chapter 7 relief. Because he took out the 401(k) loan 19 months before filing for bankruptcy, he could not have terminated the automatic repayment obligation unless he would have quit his job or repaid the loan in full, according to the opinion. Judge Arthur Harris wrote in the opinion that the “first option would have been financially irresponsible, the second financially impossible.”

The trustee said that the filing of Chapter 7 by Thompson and his wife was an “abuse,” as defined by the Bankruptcy Abuse Prevention and Consumer Protection Act if the loan repayments were added to the calculation of the Thompson’s monthly income. The court refuted this argument, saying that the 401(k) loan was considered a “secured debt” and therefore can be subtracted from a debtor’s monthly income. Judge Harris further wrote that, “Unsecured loans from 401(k) plans to plan participants are prohibited” by the Employee Retirement Income Security Act (ERISA), and that only loans that are “adequately secured are permitted.”

In May 2004, Thompson took a $29,719 loan against his 401(k) plan in an effort to help his family’s long-standing financial problems, which had become more pronounced in three to four years prior to the loan. According to the opinion, the loan was to be paid with 117 biweekly payroll deductions of $264, and was secured by 50% of his vested account balance.

However, in May 2005, the Thompsons filed for Chapter 7 bankruptcy, listing $152,600 in assets and $245,468 in liabilities. The couple initially listed the 401(k) loan as “other necessary expenses: mandatory payroll deductions,” and in an amended bankruptcy petition, the Thompsons listed the 401(k) loan as “future payments on secured claims.”