Prior to October 2005, a Chapter 13 debtor had to discontinue making 401K contributions and 401K loan repayments when he filed for Chapter 13 Bankruptcy. The Bankruptcy Court’s rationale was that this money should be used to increase the amount being paid back to the debtor’s Chapter 13 creditors.
Stopping the 401K loan repayment lead to horrible results. Once a debtor stopped repaying the 401K loan (and he had no choice but to stop), the Internal Revenue Service would treat the loan as a “cash out” and the debtor would incur a 30% tax penalty. Worse, since the “cash out” was deemed to have occurred AFTER the bankruptcy was filed, the tax penalty could not be included as part of the Chapter 13 repayment plan. When the Chapter 13 Plan was over, the debtor would be liable to the Internal Revenue Service for the tax penalty incurred due to the cash out.
In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”). BAPCPA allowed a debtor who filed for Chapter 13 bankruptcy protection to continue repaying a loan against his 401K plan, thus negating the risk of the debtor being penalized by the IRS for stopping the 401K loan repayment that had existed prior to BAPCPA.
What was not so clear was whether the Chapter 13 debtor could continue contributing into his 401K Plan. Some attorneys (including Joseph L. Grima) argued that a debtor should be able to continue contributing into his 401K plan because BAPCPA explicitly stated that such contributions were not “disposable income”. Eventually, a ruling obtained by the law firm of Joseph L. Grima & Associates P.C. in 2006 out of the Bankruptcy Court for the Eastern District Of Michigan held that contributions into a 401K Plan could continue.
Subsequent to the 2006 ruling, a Chapter 13 debtor could continue to both repay a loan against his 401K Plan and continue contributing into his 401K Plan. This all changed in 2010, when Sixth Circuit Court Of Appeals, in the case of In Re Seafort, opined (in dicta) that 401K contributions had to stop and instead be paid into the Plan for the benefit of the debtor’s creditors. This issue was not actually what was in front of the Seafort Court, but since the Sixth Circuit addressed it, albeit in dicta, lower Courts felt bound by it.
Once the Seafort decision came down, a Chapter 13 debtor could continue repaying a loan against his 401K Plan, but had to stop contributing into his 401K and instead devote the contributions to his Chapter 13 Plan for the benefit of his creditors.
This has now changed. In 2020, the issue of whether a Chapter 13 debtor could continue contributing into his 401K Plan was again in the Sixth Circuit Court Of Appeals, in the case of In Re Davis, and this time the issue was squarely in front of the Court, as opposed to In Re Seafort, and the Court had to address it head-on instead of in dicta.
The Davis Court held that 401K contributions could continue once a debtor filed for Chapter 13. The Chapter 13 debtor can now continue to contribute into his 401K plan, as well as continue repaying any loans against his 401K.