This easy question to state has a surprisingly complicated answer. This is bad news if you were hoping for a simple yes or no, but good news if you’re a fan of more complex legal analysis. In this post, I’ll discuss retirement contributions within the Chapter 7 context. In my next post, I’ll discuss retirement contributions in a Chapter 13 bankruptcy.
I. Retirement Contributions In A Chapter 7 Bankruptcy
There are at least two reasons why Chapter 7 debtors would want to continue contributing to their retirement plans (for linguistic simplicity, let’s assume we’re dealing with a 401(k) plan, since it’s easier to type “401(k)” than “retirement plan”): First, to provide for those golden years of not having to spend two plus hours a day commuting (those of you who don’t live in a traffic nightmare area like the Los Angeles environs may not understand this problem except on a theoretical level, but it’s very real here), and second, to chew up income to qualify for Chapter 7 relief.
The first reason is not a mystery to any of you reading this post. The second reason has to do with the so-called “means test” found in 11 U.S.C. § 707(b), and embodied in Form 22A, a mandatory form that is a part of any personal Chapter 7 bankruptcy filing. I recently discussed Form 22 in the Chapter 13 context (there it’s Form 22C, but the big picture calculations are the same, with just a few arithmetic differences), so I won’t go into too much detail here.
A. The Two-Part Test For Qualifying For Chapter 7 Relief
The key points to recall for our current discussion are:
(1) To qualify for Chapter 7 protection when your debts are primarily consumer debts you must pass a two-part test. If you pass the first part of the test you’re in. If you fail the first part of the test, the second part, the means test, becomes the be-all and end-all. In both parts of the test we start by calculating current monthly income (“CMI,” the six-month arithmetic average of gross income from all sources — except social security — for the six full calendar months prior to the month you file your bankruptcy papers). In the first part of the test we annualize CMI by multiplying by 12 to get the annualized CMI (“ACMI”), and compare ACMI to the median income for a family of your size. If ACMI is less than or equal to the median, you’re in. Otherwise, you proceed with the second part of the test, the portion that is really the means test.
(2) The means test involves calculating disposable monthly income (“DMI”) by subtracting taxes and social security, and reasonable living expenses from CMI. Ideally, in a Chapter 7 case we want DMI to be negative — though it can be a bit positive; but I don’t like to file a Chapter 7 with a positive DMI because I think it’s like poking the beast (i.e., the U.S. Trustee’s Office) with a sharp stick. As for the term “reasonable living expenses,” we include the IRS standard living expenses, and any additional living expenses you may have, not envisioned in the IRS standards, but that you can convince the judge are legitimate.
We will eventually answer the question posed. However, let’s begin by focusing on a 401(k) loan repayment first. After that we’ll with voluntary contributions to a 401(k).
Thus, we begin by asking: Can an ongoing 401(k) loan repayment be considered a reasonable living expense for DMI calculation purposes? That question was the focus of the Ninth Circuit’s holding in In re Egebjerg, 574 F.3d 1045 (9th Cir. 2009). The Egebjerg Court concluded that the loan repayment was NOT a reasonable living expense for DMI purposes. It used two lines of reasoning.
1. The Obligation Is Not A Secured Debt
One reasonable expense that Chapter 7 debtors typically include in Form 22A is regular payments on a secured debt. For example, if the debtor has a car or mortgage payment, the debtor can include that payment in the living expenses to be subtracted from CMI to calculate DMI. Such an ongoing obligation is unlikely to lead to an objection, unless it is a $2,000 per month car payment on a Ferrari Testarosa. (I once had a consultation with a potential client who had three car payments totaling $5,000 per month, and he wanted to file a Chapter 7 bankruptcy. He did not become a client.)
Egebjerg argued that the repayment of his 401(k) loan was a similar sort of reasonable debt repayment.
The Ninth Circuit rejected this line of argument, and reasoned that since
. . . the debtor’s obligation to repay a loan from his or her retirement account is not a “debt” under the Bankruptcy Code . . . Egebjerg’s obligation is essentially a debt to himself — he has borrowed his own money . . . the debtor may not include payments on such loans as a deduction for purposes of the means test under § 707(b)(2).
In re Egebjerg, 574 F.3d at 1049 – 50.
2. The Loan Repayment Is Not A Necessary Expense
Egebjerg also argued that his 401(k) loan repayment was a necessary monthly expense. The Court rejected that reasoning as well because a 401(k) loan repayment was not found in the IRS’s manual as a necessary monthly expense (emphasis added):
Under the statutory provisions governing the means test, debtors may deduct, in addition to payments on secured debt, their “actual monthly expenses for the categories specified as Other Necessary Expenses issued by the Internal Revenue Service.” 11 U.S.C. § 707(b)(2)(A)(ii). In turn, the Internal Revenue Manual (“IRM”) lists fifteen categories of expenses which may be considered necessary under certain circumstances, such as child care, education and court-ordered payments such as alimony and child support. IRM § 220.127.116.11. . . . [T]he IRS guidelines themselves provide that “[c]ontributions to voluntary retirement plans are not a necessary expense.” IRM § 18.104.22.168; see also In re Lenton, 358 B.R. at 658 (“[i]f future voluntary contributions to the 401k plan are not necessary expenses, it is hard to argue that the replenishment of past voluntary contributions to the 401k account by repaying loans is a necessary expense.”
Id. at 1051 – 52.
It is worth noting that the quote from In re Lenton that the Court chose to include stated that “. . . future voluntary contributions to the 401k plan are not necessary expenses . . .”
In sum, neither voluntary retirement contributions, nor retirement loan repayments, can be used to offset income as a way to qualify for Chapter 7 relief.
B. Involuntary Retirement Contributions
Suppose a debtor works for a governmental unit that has a mandatory retirement plan, e.g., CalPERS, STRS, or FERS. Can that debtor use those retirement deductions to offset income for DMI calculation purposes? Now the answer is “Yes.”
For example, the Court in In re Brace, 430 BR 513, 514-15 (Bankr. N.D. Ill. 2010) held:
Section 707(b)(2)(A)(ii)(I) provides that a debtor may deduct from current monthly income “the debtor’s actual monthly expenses for the categories specified as Other Necessary Expenses issued by the Internal Revenue Service for the area in which the debtor resides[.]” 11 U.S.C. § 707(b)(2)(A)(ii)(I). The categories of Other Necessary Expenses can be found in section 22.214.171.124 of the Internal Revenue Manual (the “IRM”). In re Barraza, 346 B.R. 724, 730 (Bankr. N.D. Tex. 2006). Although the IRM does not include a category addressing 401(k) loan repayments as Other Necessary Expenses, it does have a category for “involuntary deductions.” Specifically, the IRM allows an “involuntary deduction” from income if the deduction is a requirement of the debtor’s job. Id. (citing IRM § 126.96.36.199 (05-01-2004)). Thus, repayment of a retirement loan is considered an involuntary deduction for purposes of the means test only if repayment is a requirement of the debtor’s employment
C. Contributions When The Means Test Is Not A Problem
Suppose a debtor passes the means test without including either a voluntary 401(k) deduction, or 401(k) loan repayment. Can the debtor continue to make the payments anyway?
You might wonder how a debtor who passes the means test without the retirement deductions can have the ability to make such contributions. There are two situations in which this can happen.
First, the debtor can pass the first part of the test for qualifying for Chapter 7 relief without even having to calculate DMI. In this situation, the debtor may be living very frugally, and thus has enough income to contribute to a 401(k), even though he passed the first part of the test. If that happens, since the debtor passed the test he’s in Chapter 7, and can still make 401(k) contributions, because they had nothing to do with qualifying for Chapter 7 relief.
Second, the debtor may have passed the means test because of frugal living, with actual living expenses way below the IRS standard expenses. If that happens, the debtor can still contribute to the retirement plan because those payments played no role in qualifying for Chapter 7 protection.
In my next post, I’ll answer the question, “Can I continue to contribute to my retirement while in Chapter 13 bankruptcy?”