Ninth Circuit Joins Consensus: 401k Loans Not Deductible As Secured Debt Under Means Test

Joining what has become the consensus position, the Ninth Circuit has held that payments on a 401k loan may not be deducted under the chapter 7 means test. Egebjerg v. Anderson, 2009 U.S. App. LEXIS 11651 (9th Cir. 5/29/09). The opinion highlights a major inconsistency in the way that BAPCPA treats retirement plan loans.

The Ninth Circuit ruled that a loan from a retirement plan was not a debt and therefore was not a secured debt which could be deducted on line 42 of the means test. The crux of the ruling is found in the following language:

The reasoning behind these decisions is straightforward. Egebjerg’s obligation is essentially a debt to himself — he has borrowed his own money. (citation omitted). Egebjerg contributed the money to the account in the first place; should he fail to repay himself, the administrator has no personal recourse against him. (citation omitted). Instead, the plan will deem the outstanding loan balance to be a distribution of funds, thereby reducing the amount available to Egebjerg from his account in the future. (citation omitted). This deemed distribution will have tax consequences to Egebjerg, but it does not create a debtor creditor relationship.

Opinion, pp. 6386-87.

In my view, this is an area where the law has gone astray. I recently received a loan from my 401k plan. The document which I signed was entitled "Loan Agreement, Note and Pledge." In pertinent part, the document stated:

For value received the Borrower agrees to pay the Lender the amount of $________ principal and interest at an annual interest rate of ______%. The length of the loan shall be ___ months. Payment shall be made to the Trustee of the Plan in the amount of $_______ Semi-Monthly beginning ______ and ending _______. Prepayment of the unpaid principal and accrued interest may be made by the Borrower at any time without penalty.

Pledge to secure this loan: Borrower hereby irrevocably pledges his/her vested account balance under the Plan in satisfaction of any unpaid balance and associated costs due and payable upon default.

Thus, there is a Lender, a Borrower, a promise to pay and a security interest. The fact that the security interest is in funds contributed to a retirement plan should not make a difference. While the funds in the retirement plan originated from my contributions, they are no longer under my dominion and control. If I buy 1 share of Berkshire Hathaway and then borrow money secured by that stock, I have in essence borrowed my own money; my money has just taken the form of Berkshire Hathaway stock instead of cash. The pledge of the stock allows me to keep my money in the form of the stock while having access to it through the intermediary of the bank. The analogy of a pledge of stock is particularly appropriate, since I have the assets in my 401k plan invested in mutual funds.

Besides ignoring the form and substance of the transaction, the consensus position is inconsistent with the manner in which 401k loans are treated elsewhere by BAPCPA. BAPCPA included three provisions specifically aimed at protecting retirement plan loans. Section 362(b)(19) provides that retirement plan loans are not subject to the automatic stay, thus allowing their continued collection in a bankruptcy case. Section 523(a)(18) provides that a "debt" owed to a retirement plan is non-dischargeable, thus protecting a debtor from tax liability resulting from discharge of the loan. Finally, Section 1322(f) provides that a retirement plan "loan" may not be altered by a chapter 13 plan and may not be included in calculation of the debtor's disposable income. There are two important points here. The first is that since the Code refers to these obligations as "debts" and "loans" in other places, why would they not be a debt or a loan under the means test? Secondly, the purpose of the chapter 7 means test is to identify debtors who can afford to pay their debts under a chapter 13 plan. Therefore, it makes logical sense to interpret the chapter 7 means test in light of what would be deductible in a chapter 13 case.

Unfortunately, it looks like the train has left the station on this issue and the Ninth Circuit's position does reflect a consensus among courts. As a result, this may be an issue requiring a legislative fix.

Judge Kelly Finds 401k Loans Deductible Under Means Test

Judge Larry Kelly has recently held that 401k loans may be deducted in performing the chapter 7 means test. In re Otero, 06-30691 (Bankr. W.D. Tex. 11/2/06). BAPCPA expressly designates 401k loans as allowable expenses in chapter 13 cases. 11 U.S.C. Sec. 1322(f). However, there is not a similar provision with respect to the chapter 7 means test. Judge Kelly's ruling differs from a recent decision on this issue out of the Northern District. In re Barraza, 346 B.R. 724 (Bankr. N.D. Tex. 2006).

BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.

When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"

However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.

Judge Kelly stated:

"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."

Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out. http://stevesathersbankruptcynews.blogspot.com/2006/08/means-testing-opinions-strictly.html

Update:

The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.

The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.