Must a participant in bankruptcy repay a 401(k) loan?


One of your employees has informed you that it is possible she will have to declare bankruptcy. She took out a $20,000 loan last year on her 401(k) plan, with a five-year repayment plan. Can she stop making loan repayments or renegotiate her repayments?


Generally, no. The failure of an active employee to make required loan repayments will result in a taxable distribution. A loan made to a participant from a qualified 401(k) plan (with the exception of loans used to acquire, but not refinance, a principal residence) that is not required to be repaid within five years from the date on which the loan is made is automatically treated as a distribution. The Bankruptcy Code generally prohibits a creditor from attempting to collect on a debt after a debtor files for bankruptcy. However, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) clarified that participant loans in 401(k) plans are not discharged in bankruptcy, and ongoing loan repayments by payroll deduction are permitted to avoid a loan default and resulting taxation.

Loan extension. A loan may be extended beyond the original repayment date, but only if the original loan period was less than five years. For a five-year repayment period that is later extended past the original five years, the outstanding balance at the time of extension is treated as a distribution at the time of extension.

Source: Internal Revenue Code Secs. 401(k) and 72(p)(2)(B), as reported in Employee Benefits Management Directions, Issue No. 530, January 29, 2013.

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