May a person contribute to 401(k) retirement plan during a Nebraska Chapter 13 case?
THE RULE PRIOR TO 2005:
Prior to the Bankruptcy Reform Act of 2005 the answer was fairly simple: No. Contributions to a 401(k) retirement plan are voluntary, and prior to 2005 it was commonly known that contributions were not “necessary” to the support of a debtor.
The maximum required length of a plan was only three years, so to deny this deduction was not a terrible burden on debtors. No matter how high their income was, debtors only had to be in Chapter 13 for three years.
THE RULE AFTER 2005:
But that all changed in 2005 and now higher-income debtors are required to spend up to five years in Chapter 13. Monthly payments are now, in theory, determined by a Means Test based on income received during the prior six months.
The entire intent of the new law was to make filing bankruptcy more difficult and to force debtors to pay back a greater portion of their debts
But the new 6-month income test also contained a new deduction: qualified retirement plan contributions. Debtors might have to repay more of their debts, but at least they could contribute to a voluntary retirement plan, or so it appeared.
CONFUSION OVER RETIREMENT PLAN CONTRIBUTIONS:
The problem with applying the Bankruptcy Reform Act of 2005 is that nobody really understands what it says. The language is confusing and it contains incomplete “hanging sentences.”
As a result, bankruptcy courts have crafted different interpretations of whether a debtor may contribute to a voluntary 401k plan during a Chapter 13 case. (See In re Penfound, 6th Cir 2021)
FOUR INTERPRETATIONS ABOUT RETIREMENT CONTRIBUTIONS:
- Majority View–the Johnson View. The majority of bankruptcy courts hold that a debtor may fund a 401k plan during Chapter 13 if the contributions are made in “good faith.” Under this view bankruptcy courts look at all the relevant factors to see if the contributions are justified. Contributions must be reasonable in light of the debtor’s income, age, health, existing retirement balances, previous contribution percentages, the type of debt owed, and the amount of debt owed. See Baxter v. Johnson (In re Johnson), 346 B.R. 256, 263 (Bankr. S.D. Ga. 2006).
- Priggee Interpretation: Debtors are never permitted to contribute to voluntary retirement plans during chapter 13. In re Prigge, 441 B.R. 667, 677 & n.5 (Bankr. D. Mont. 2010)
- Seafort-BAP Interpretation. A debtor may continue to contribute to a 401k plan an amount they were contributing “at the time” the case was filed. In other words, you may not start contributing to a program after the case is filed.
- CMI Interpretation. A debtor may only claim a monthly deduction for an amount equal to the average amount contributed in the six months prior to filing.
NEBRASKA’S RETIREMENT CONTRIBUTION RULE:
There is no Nebraska or 8th Circuit case exactly on point, but it appears that Nebraska follows the Good Faith rule of Johnson. A reasonable retirement contribution is allowed.
Counsel for the Chapter 13 Trustees often speak about a higher-income debtor’s level of retirement contributions. Objections are raised on “good faith” grounds instead of technical arguments. However, when presented with a case involving a high-income debtor who offers to pay very little to unsecured creditors while making significant contributions to their own retirement plan, is is common for the trustee to object to the debtor’s budget.
OBSERVATIONS AND FINAL COMMENTS:
It is extremely common for debtors to liquidate or to stop contributions to a retirement plan before bankruptcy. The vast majority of people I meet do not realize that retirement funds are shielded from creditor claims and they feel a strong moral duty to liquidate their savings to pay debts.
The other observation is that liquidating a retirement plan to pay debts rarely provides enough funds to pay back all the debt. At best only a portion of debt is paid and income taxes and penalties frequently consume nearly half of the funds withdrawn. Rarely does it make sense to use retirement savings to pay debts.
Those who do use retirement savings to pay debts suffer a tremendous blow. They forfeit decades of savings they can never restore.
When it becomes clear that filing bankruptcy is necessary, a debtor should cease to pay unsecured debts (credit cards & medical bills) and they should consider contributing to a retirement program prior to filing bankruptcy. Bankruptcy courts may balk at contributions to 401k plans if those contributions were not being made prior to filing a case.
Most debtors wait too long to visit a bankruptcy attorney. By the time they do visit one they have wiped out savings that would have been fully protected in the bankruptcy case.
The lack of retirement savings is often a strong factor in deciding to file bankruptcy. Although a young person may learn a hard but valuable lesson in paying back debts incurred foolishly, those in their middle years are running out of time to save up for retirement. Filing bankruptcy enables a person to protect the retirements they have saved so far and frees up future income to devote to that purpose. Bankruptcy has as much to do with planning for the future as it does in cleaning up the past.
Image courtesy Leigh Blackall & Flickr