Participant with loan is filing Bankruptcy

[Guest mmc]

A participant loan is being paid through payroll deductions. The participant is filing for bankruptcy and the attorney is sending the plan sponsor a letter to stop payroll withholding for the loan payments.

I thought 401(k) plans were protected from bankruptcy proceedings, or does that apply to protection from creditors?

If the participant rescinds on the payroll withholding, must the plan sponsor comply?

The loan is then in default, correct? Does the cure period apply in this situation, or is the loan immediately in default?

[QDROphile]

Search for other posts on this subject. The participant's account in the 401(k) plan is protected. However, the 401(k) plan, as creditor, cannot collect on its debt when collection is stayed in bankruptcy. The bankruptcy is not trying to get at assets in the 401(k) plan. A default caused by a stay is no different from any other default from the perspective of tax consequences unless the plan has special provisions to cover bankruptcy, which is unlikely.

[Guest CAM223]

The company cannot continue to withhold loan payments for a bankrupt participant. If payments continued it would favor the participant who would be paying himself back 100% of the plan loan but his other creditors would not receive 100 cents on the dollar. There is caselaw on this issue which mandates that the company stop the loan payments once notified by the bankruptcy court.

[TBob]

the attorney is sending the plan sponsor a letter to stop payroll withholding for the loan payments.

I would think that you would need the official notice from the bankruptcy court before you would proceed to stop collection efforts including the payroll deductions. I am no attorney but I would wait for the bankruptcy court and not act on the letter from the attorney.

[mbozek]

An individual who files for bankruptcy must include a schedule of creditors listing all outstanding debts as of the date of the filing of the bankruptcy petition. The court then sends a notice to each creditor ordering them to cease collection of the debt. If the plan loan is not included on the schedule the plan admin must continue to collect the loan. I once reviewed a bankruptcy petition where the employee had taken out two loans from a 401k plan- one before the petition was filed and one immediately after the filing. The payment of the first loan was stopped but collection on the second continued. The rule against continuing payments after filing the bankruptcy petition only applies in Ch 13 cases-wage repayments where the employee negotiates to continue payments to creditors from current wages without being discharged from the debts. In Ch7 bankruptcy the amount of the assets /debts owed is fixed as the date of filing the petition and the employee can elect to repay the loan to prevent the outstanding balance being taxed as income because of default on the loan.

[Guest philc]

Understand that even though the loan repayments are suspended, there still is an obligation to repay. And if a participant cannot, what I have been seeing is default and a deemed distribution occurs. But if the participant would otherwise qualify for a distribution, couldn't plan just default and do an offset?

[Guest adubin]

I believe the new Bankruptcy Reform Act signed by the President on April 20 removed the automatic stay applicable to loan repayments to qualified plans. If no stay applies, repayments could only be suspended as permitted under Code Section 72(p). Note that the act is effective with respect to bankruptcy filings made after the effective date and does not affect current bankrupt estates.

[R. Butler]

The company cannot continue to withhold loan payments for a bankrupt participant. If payments continued it would favor the participant who would be paying himself back 100% of the plan loan but his other creditors would not receive 100 cents on the dollar. There is caselaw on this issue which mandates that the company stop the loan payments once notified by the bankruptcy court.

Cases include:

In re Scott 142 B.R. 126 (E.D.Va. 1992)

In re Anes 23 EBC 1953 (3rd Cir. October 27, 1999)

Harshbarger v. Pees, 66 F.3d (6th Cir. 1995)

The loan is then in default, correct? Does the cure period apply in this situation, or is the loan immediately in default?

Look at the plan document. It should specifically state when the default occurs