Pension & Benefits News Debtor’s monthly 401(k) contributions not subject to claims of unsecured creditors as disposable income
Thursday, October 15, 2020

Debtor’s monthly 401(k) contributions not subject to claims of unsecured creditors as disposable income

By Pension and Benefits Editorial Staff

Monthly 401(k) contributions regularly withheld from a debtor’s wages prior to her bankruptcy could be excluded from her disposable income and thus, shielded from unsecured creditors, according to the U.S. Court of Appeals in Cincinnati (CA-6).

Disposable income in Chapter 13 bankruptcy. A debtor proposed a bankruptcy plan under which she would pay her unsecured creditors a total of $19,380 (60 monthly payments of her monthly disposable income of $323). The debtor reported gross monthly income of $5,627 but claimed $5,304 in allowable monthly expenses. Among the claimed expenses, was a monthly $220.66 contribution to the 401(k) of her employer, which she wished to continue during the term of her bankruptcy.

The bankruptcy trustee objected to the debtors’ plan, maintaining that the wages withheld as voluntary 401(k) contributions were disposable income under the Bankruptcy Code. The bankruptcy court sustained the trustee’s objection, citing dictum in the Sixth Circuit’s ruling in Seafort v. Burden (CA-6 (2012) 669 F.3d 662), which suggested that the Bankruptcy Code always counts voluntary retirement contributions as disposable income, even if the debtor began making those contributions prior to bankruptcy.

The debtor subsequently filed an amended bankruptcy plan that would pay her unsecured creditors $519 each month, reflecting, in part, the addition of her monthly 401(k) contributions to her disposable income calculation. The debtor then objected to her own plan, preserving the disposable income issue for appellate review. The bankruptcy court confirmed the amended plan over the objection of the debtor, who then secured a certification authorizing a direct appeal to the Sixth Circuit.

401(k) contributions are not disposable income. Under Bankruptcy Code Sec. 1325(b)(1), a bankruptcy plan cannot be approved unless it requires all of a debtor’s projected disposable income received in the applicable commitment period to be applied to payments to unsecured creditors. The Code defines “disposable income” as the debtor’s current monthly income, less amounts reasonably necessary to be expended for the maintenance or support of the debtor.

Prior to 2005, the majority view in the bankruptcy courts was that wages voluntarily withheld as 401(k) contributions were part of a debtor’s disposable income. However, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), enacted in 2005, amended the Bankruptcy Code to provide in Sec. 541(b)(7) that the property of the bankruptcy estate does not include any amount withheld by an employer from the wages of employees for payment as contributions to a 401(k) retirement plan. A “hanging paragraph” within Sec. 541(b)(7)(A) further provides that the rules apply “except that such amount under this subparagraph shall not constitute disposable income as defined in section 1325(b)(2).”

The debtor argued that the “hanging paragraph” clearly excludes 401(k) contributions from disposable income for purposes of Sec. 1325(b)(2). However, under a different fact pattern, the Sixth Circuit, in Seafort, held that a debtor, following repayment of a 401(k) plan loan, could not use the newly available income to begin making 401(k) contributions. According to the Sixth Circuit, “post-petition income that becomes available to debtors after their 401(k) loans are fully repaid is ‘projected disposable income’” under section 1325(b)(1).

The issue before the Sixth Circuit, thus, was whether the reference in the hanging paragraph to amounts that “shall not constitute disposable income,” encompasses the continued monthly 401(k) contributions the debtor sought to exclude from her disposable income in her proposed bankruptcy plan. The debtor argued that the relevant “amount” of the contributions to be excluded from her disposable income is the sum her employer withheld from her wages each month. By contrast, the trustee suggested that the “amount” excluded is simply the aggregate 401(k) contributions that the debtor had accumulated in her 401(k) account prior to her bankruptcy.

Applying principles of statutory construction to the unartfully drafted provision, the court concluded that the hanging paragraph is best read to exclude from disposable income the monthly 401(k) contribution amount that the debtor’s employer withheld from her wages prior to her bankruptcy. Such an interpretation, the court reasoned, gives a meaningful effect to Congress’s instruction in Sec. 541(b)(7) that 401(k) contributions “shall not constitute disposable income.”

Stressing the narrowness of its decision, the court explained that it was not “disturbing” the analysis in Seafort, which rejected the view that the hanging paragraph allowed debtors to begin making 401(k) contributions post-petition and then deduct those contributions from their disposable income. The court, reflecting the intention of Sec. 541(b)(7), merely concluded that the hanging paragraph is best read to exclude from disposable income a debtor’s post-petition monthly 401(k) contributions, so long as those contributions were regularly withheld from the debtor’s wages prior to her bankruptcy.

Source: Davis v. Helbling (CA-6).

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