Courts are split three ways on whether chapter 13 debtors can make contributions to 401(k) plans. Some courts permit none whatsoever, while others permit contributions no larger than what the debtor was contributing before bankruptcy.

Bankruptcy Judge Marvin Isgur of Houston took the third approach by allowing contributions up to the amount permitted by the IRS Code, regardless of whether the debtor had been making contributions before filing the chapter 13 petition.

So far, only one circuit has spoken on the topic. In Davis v. Helbling (In re Davis), 960 F.3d 346 (6th Cir. 2020), the Sixth Circuit rejected the holding by some courts that contributions are never included in “disposable income,” whether or not the debtor was making contributions before bankruptcy. The majority in Davis held that a debtor who was making contributions to a 401(k) before bankruptcy may continue making contributions in the same amount by deducting the contributions from disposable income.

The dissenter in Davis would have held that a debtor cannot make contributions after bankruptcy, even if he or she was making them beforehand. To read ABI’s report on Davis, click here.

In a unanimous opinion the next year, the Sixth Circuit held that a chapter 13 debtor may not make 401(k) contributions if the debtor had not been making contributions before bankruptcy, even if (1) the debtor had a history of making contributions in prior years when he was able, and (2) the debtor was not eligible for a 401(k) plan in the months before bankruptcy. Penfound v. Ruskin (In re Penfound), 7 F.4th 527 (6th Cir. Aug. 10, 2021). To read ABI’s report on Penfound, click here.

Judge Isgur’s Debtor

A husband and wife filed a chapter 13 petition. Only the husband, age 58, was employed. They had not been making contributions to the husband’s 401(k) plan before filing. In fact, they had been forced to take almost $12,000 in loans from the 401(k).

The plan was designed to have a 24% recovery for unsecured creditors. The plan called for the debtors to contribute $1,700 a month to the 401(k) plan. The contribution was less than the IRS Code permits but more than the amount matched by the husband’s employer.

The chapter 13 trustee objected to confirmation, contending that the debtors were improperly deducting the 401(k) contributions from disposable income, lowering the recovery for unsecured creditors. The trustee also argued that the contributions meant that the plan was not filed in good faith.

Deducting Contributions from Disposable Income

In his April 6 opinion, Judge Isgur first tackled the question of whether 401(k) contributions are deducted from projected disposable income.

The Bankruptcy Code only defines “disposable income,” not “projected disposable income.” In Section 1325(b)(2), “disposable income” means “current monthly income received by the debtor . . . less amounts reasonably necessary to be expended.”

To define what “projected” adds to the equation, Hamilton v. Lanning, 560 U.S. 505 (2010), comes into the equation. The Court said that “the court may account for changes in the debtor’s income or expenses that are known or virtually certain at the time of confirmation.” Id. at 524.

“Whether 401(k) contributions are a permissible adjustment hinges on further interpretation of the Code,” Judge Isgur said.

Next, Judge Isgur dealt with Sections 541(a) and 541(b). The former brings assets into the estate, while Section 541(b) excludes some assets from the estate. Judge Isgur spent the better part of his opinion deciding whether Section 541(b) excludes assets from the estate only at the time of filing or if it also excludes assets from the estate that come to the debtor after filing.

The so-called hanging paragraph in Section 541(b)(7) further complicates the question. First, the subsection excludes employee benefit and deferred benefit plans from the estate. That portion of the section clearly excludes 401(k)s from the estate that the debtor owns on filing. But does it also shield salary that the debtor will receive after filing but intends to contribute to a 401(k)?

The hanging paragraph may have been intended to clarify the meaning as to contributions after filing, but lousy drafting only made matters worse. The hanging paragraph at the end of Section 541(b)(7) says:

except that such amount under this subparagraph shall not constitute disposable income, as defined in section 1325(b)(2).

Judge Isgur decided that Section 541’s “plain language” means that the exclusions in Section 541(b) “do apply to property acquired after” filing. He cited the Collier treatise for the same interpretation. He went on to say that the “best interpretation of the Code’s text and purpose excepts post-petition 401(k) contributions from the debtors’ disposable income.”

To bolster his conclusion, Judge Isgur noted that Section 1306(a) “modifies § 541 generally, not just one subsection of § 541.” He therefore concluded that Section 1306(a) “should be read to incorporate § 541(b)’s exceptions as well as modify § 541(a)’s inclusions.” Furthermore, he said that Section 541(b) “contains no qualifiers or language indicating its application is limited either by time or to a specific section.”

Reading Sections 1306 and 541 together, Judge Isgur held that they should be “read together to subject a chapter 13 debtor’s post-petition wages to the exception for 401(k) contributions in § 541(b)(7).”

How Much to Exclude?

Having decided that 401(k) contributions can be deduced from disposable income, Judge Isgur asked, “How much?”

Surveying cases going every which way, Judge Isgur said that the “more common view is that any amount of the debtor’s post-petition income can be contributed to a 401(k), so long as that contribution is made in good faith,” approvingly citing another bankruptcy judge in the Southern District of Texas.

In Judge Isgur’s way of thinking, only nonbankruptcy law constrains how much a debtor can contribute. From the point of view that contributions are not estate property, he said that the bankruptcy court has no authority to regulate the use of nondebtor property.

Was the Plan Filed in Good Faith?

Although the Bankruptcy Code has no limitation on 401(k) contributions, the Code does require that plans be filed in good faith.

Judge Isgur said it was “difficult to find a lack of good faith” when the debtor planned on contributing less than the IRS Code permits, but the trustee contended there was no good faith because the 401(k) contributions were “unreasonably high” compared to what creditors were receiving and because the debtor had not been contributing before bankruptcy.

Judge Isgur rejected these contentions, saying that “increasing 401(k) contributions above the amount contributed before bankruptcy is expressly allowed by the Code, and doing what is allowed by the Code cannot be evidence of bad faith.”

Given the husband’s poor health and “low pre-petition savings,” Judge Isgur said that the desire to “save as much as possible now is reasonable, particularly in light of the forward-looking nature of chapter 13.”

Judge Isgur added a caveat in confirming the plan: The debtors could deduct the contributions from disposable income as long as they were actually making the contributions. He required the debtors to include a special provision in the plan calling for periodic reports to the trustee showing that the debtors were making the 401(k) contributions.