Should 401k Loans Be Used to Avoid Bankruptcy?

People will do just about anything to avoid bankruptcy.  However, taking out a loan against your 401k is not advisable, for multiple reasons.  First, in most chapter 7 bankruptcies that we do, our clients have their debts discharged while keeping their 401k intact.  Avoiding this legal and popular form of protection against your creditors will, in many cases, only push you further into the hole of debt. Add to that putting your retirement at risk, and you’ve compounded the problem exponentially.

Let’s say you use the 401k loan to pay off your creditors.  While you’ve managed to get the collections agencies and threats of wage garnishment off of your back, you’re still responsible for paying yourself back and restoring the funds in your 401k.  While it can certainly be argued that the interest rates of 401k loans is significantly lower than the rates on most credit cards, you should keep in mind that 401k loans must be paid back within a shorter amount of time than many other types of loans or lines of credit.  This means that your monthly payment to your 401k will likely be high. 

If for some reason you are unable to make this monthly payment, the money will be treated as income and you will likely have to pay a 10% early withdrawal penalty since it would be considered a distribution from a tax-deferred plan.  What this means is that in addition to the penalty, you’ll have to pay income taxes on the money you took out as a loan.  Also, if you are unable to continue working or change employers, you will be required to pay back the loan in full, immediately. 

Now weigh all of that against this fact: if a debtor files bankruptcy, most states’ exemptions will keep your 401k protected. This means that you’ll have some of your debt discharged while keeping your retirement money intact.  The benefits of doing this definitely outweigh the benefits of taking out a loan on your 401k to avoid bankruptcy.