One of the most common situations we bankruptcy attorneys see in our practice is clients that have borrowed money from their 401k or other retirement plans to try and keep up with their debts. Usually this is as a last resort before considering bankruptcy, but the last resort really should be whatever step they took before borrowing from their retirement.
Borrowing against one’s retirement is bad for a number of reasons.
Depleting your 401k retirement will not help your future
You spent a lot of hours earning the money that is in your retirement and took the advantage of a retirement account to do so. These accounts have many benefits, including that they are not taxed until you withdraw the money. You also, in many cases, get a tax deduction for contributing to them as it reduces your gross income. To take out a 401k or retirement loan, you must pay a fee to do so, making it even less attractive from a financial standpoint.
Failure to repay a 401k or other retirement loan will result in tax consequences.
If a retirement loan is not repaid, not only do you lose the fees you have to pay to take out the loan in the first place, but the loan then becomes taxable income to you. Depending on your other income and financial situation, this can result in a significant tax debt.
Payments on retirement loans do not count towards bankruptcy eligibility
People think that a 401k loan is the same as a loan against their car, or house. It is not. You are simply repaying yourself. As such, most (if not all) bankruptcy courts will not include the amount being repaid when analyzing your budget to see if you have income available to pay your creditors. Thus, if you have net income of $3,000 per month, and necessary living expenses (such as rent, mortgage, car payment, food, clothing) of $3,000 per month, but $700 of that $3,000 is your retirement loan deduction from your paycheck, you will likely not qualify for a Chapter 7 case, and would have to do a repayment plan in a Chapter 13 (or Chapter 11) instead.
This is one of the biggest obstacles clients of mine face. They finally run out of options, and money, and decide they need a fresh start and want to file a bankruptcy but because of the 401k loan (which they think they MUST pay), they don’t have any surplus income, yet also may not qualify for a Chapter 7 (which requires no repayment to creditors).
Know the Risks Before Borrowing
I’m not saying that it never makes sense to borrow against your retirement. Sometimes using it to save your home can be as important as the future benefit from the retirement funds themselves. But be sure to understand the problems you are getting yourself into by doing so, and use that when weighing your decision.
This article is part of my bankruptcy alphabet series.
Image Courtesy of Kenteegardin