Should Chapter 7 Debtors be Allowed to Deduct 401(k) Loan Payments on the Means Test?

The County is required by federal law and the documents that govern its 401(k) plan and loans made thereunder to make such payroll deductions until the loan is repaid or Plaintiffs employment with the County ends.
— County of Ventura

Debtors filing for Chapter 7 relief in the Ninth Circuit are prohibited from deducting 401(k) loan repayments on the Chapter 7 means test.  In the case of a debtor we represented, his 401(k) loan payments were 22% of his gross income. One would think that the loan payments his employer forcibly deducted from his paychecks would be deducted from the income on his means test.  Such deductions are effectively like loan payments on secured property.  They must be made and they reduce available funds to other creditors.

In re Egebjerg, described more completely belowdisallowed 401(k) loan repayment deductions on the means test because the Ninth Circuit held that debtors can remain employed and cancel 401(k) loan repayments.  Debtors might be able to live with that if the law was consistent. If the reason 401(k) loan payments are not deducted from the means test is that they may be terminated at will by a debtor, then they should be terminable at will by a debtor.

Our client was denied the right to end the withholding of loan repayments from his paychecks because his employer, the County of Ventura, claimed it was against Federal law for them to do so. Debtors are at the losing end of both sides of this argument.  In essence, the following two statements result in a situation in which debtors with large 401(k) loan repayments who seek to file for Chapter 7 protection can only lose.

Ninth Circuit Bankruptcy Law provides, on the one hand, that debtors may not deduct 401(k) loan payments because repayment is not a mandatory condition of employment.  Debtors allegedly have the right to terminate loan repayments, take the tax hit, and remain employed.

Federal law also mandates, in contradiction to the Ninth Circuit logic and holding, that debtors may be prevented by their employer from ending 401(k) loan repayments.  Instead, a debtor may be told Federal law prohibits the very option relied upon by the Ninth Circuit and, instead, be provided the option of ending his or her employment or agreeing to mandatory withholding of loan repayments from paychecks to remain employed.

Why is the law this way?  This outcome was mandated in a Ninth Circuit opinion.  That opinion is In re Egebjerg, 574 F.3d 1045, 1047 (9th Cir. 2009)

The 401(k) loan repayments themselves are voluntary in the sense that Egebjerg can simply ask the loan administrator to treat his outstanding loan balance as an early withdrawal from his 401(k) and thereby relieve himself of a future repayment obligation. Doing so would have tax consequences, but Egebjerg would retain the use of most of the money loaned.
— In re Egebjerg, 574 F.3d 1045, 1051 (9th Cir. 2009)

The Ninth Circuit three-judge panel described its inquiry at the opening of In re Egebjerg.  "We consider whether a debtor's repayment of a 401(k) loan constitutes a “monthly payment on account of secured debts” or an “[o]ther [n]ecessary [e]xpense” that can be deducted from a debtor's monthly income for purposes of calculating the debtor's disposable monthly income under § 707(b)(2)." In re Egebjerg, 574 F.3d 1045, 1047 (9th Cir. 2009). While this is the main issue in this matter, it is not the only law guiding the treatment of 401(k) loans. 

The treatment of 401(k) loans is dealt with in the bankruptcy code in several ways. First, let us be clear that Plaintiff is not trying to declare his 401(k) loan discharged in bankruptcy. That is obviously prohibited by law. Second, he did not try to use the automatic stay to stop the 401(k) payments during his bankruptcy.  The Bankruptcy Code expressly disallows that option. 

Despite the findings in this decision, when our client told his employer, the County of Ventura, that he was exercising his right to end his payroll deduction repayment of his 401(k) loan, he was told that if he wanted the deductions from his paycheck to stop, he needs to quit.

Courts have examined the IRS Manual in detail to determine whether payment of 401(k) loans is a "mandatory" requirement to keep one's job.

The court in In re Barraza, 346 B.R. at 730 noted, “[t]he Internal Revenue Manual has no specific category addressing 401(k) loan repayments as Other Necessary Expenses.” The court recognized that there is a general category for “involuntary deductions” but declined to use it.

The court noted that the IRS Manual permits an “involuntary deduction” to be deducted from income if the deduction is a requirement of the debtor's job. IRM § (05–01–2004). Examples of involuntary deductions include union dues, uniforms, and work shoes.  The debtor in this case introduced two employer's 401(k) plan descriptions. Both plans provided that loans must be repaid via payroll deductions. Both of the debtor's employers routinely deducted the loan repayments from his paychecks.

The reasoning behind these decisions is straightforward. Egebjerg’s obligation is essentially a debt to himself—he has borrowed his own money. [S]hould he fail to repay himself, [ ] the plan will deem the outstanding loan balance to be a distribution of funds [ ]. This deemed distribution will have tax consequences to Egebjerg [ ]. “Nonpayment comes with liability for income taxes and penalties, but non-payment is a valid, lawful alternative.”
— In re Egebjerg, 574 F.3d 1045, 1049 (9th Cir. 2009) (Citations Omitted)

The court found, however, that the requirement to repay the 401(k) loans is not a job requirement in the sense that union dues, uniforms, and work shoes are. The consequence of a debtor's failure to comply with the requirement to pay union dues, wear a particular uniform, or wear certain shoes is, in all likelihood, loss of employment. By contrast, the consequence of the debtor defaulting on his 401(k) loans would be that the loans are treated as taxable distributions. Consequently, the court concluded, the plan loan repayments do not qualify as “involuntary deductions” under the Internal Revenue Manual.


Plaintiff's Motion for Summary Judgment

We represented a debtor named Joseph W. Henry (“Plaintiff”) who sued the County of Ventura to test the theory that he could voluntarily put an end to his 401(k) loan repayment. He had worked for the County of Ventura as a road maintenance worker for twenty-four years. During that time, he invested in his 401(k) through regular contributions. In 2013, he suffered a series of financial hardships and was forced to borrow from his 401(k). His 401(k) loan payments for his two loans total $1,005 per month. He typically earned $4,557 in gross pay, but his loan burden, taxes, health insurance, and Union Dues leave him with only $1,359 per month on which to live. 

Henry had considerable debt and filed for protection under Chapter 7 of the Bankruptcy Code on August 31, 2015. To be able to afford an apartment, food, and the basic necessities, Debtor filed for bankruptcy protection to get a fresh start, but that fresh start was denied by the County of Ventura. Plaintiff instructed the County of Ventura to stop withholding his 401(k) loan repayments from his paychecks. The County refused, claiming Federal law mandates that it obtain its monthly loan payments through after-tax withholding.


On March 17, 2016, Judge Peter Carroll issued an order abstaining from exercising jurisdiction over this matter. 

ORDERED that the court, in the interest of justice, abstains from exercising jurisdiction over the claims made the basis of Plaintiff’s complaint in this adversary proceeding pursuant to 28 U.S.C. § 1334(c)(1) and that the adversary proceeding is dismissed without prejudice; and it is further ORDERED that the Motion, Cross-Motion, and status conference are off calendar.

Judge Carroll indicated that the issue could only be heard in a United States District Court because disputes over ERISA qualified pension plans were assigned to the exclusive jurisdiction of the District Courts.

The issue therefore remains unresolved.  Resources for those interested are linked below.