Chapter 7 bankruptcy is designed to provide a fresh financial start for debtors who have little or no disposable income. To qualify for Chapter 7 relief, your disposable income must be low enough to pass the bankruptcy means test. Whether you can deduct your retirement contributions to reduce your disposable income on the means test depends on whether they are mandatory or discretionary. Read on to learn more about which retirement contributions can help you pass the means test.
(For more articles on the means test, see our Chapter 7 Bankruptcy Means Test topic area.)
What Is the Means Test?
In order to qualify for Chapter 7 bankruptcy, you must pass the means test. The means test looks at your income and expenses and determines if you can repay a portion of your unsecured debts. If you can, you cannot file for Chapter 7 and instead must file for Chapter 13 bankruptcy.
For more detailed information on how the means test determines whether you qualify for Chapter 7 bankruptcy, see our Chapter 7 Means Test topic area.
When Expenses & Allowed Deductions Pay a Role in the Means Test
Depending on your income, you may not have to use any deductions in order to pass the means test and qualify for Chapter 7 bankruptcy. The means test compares your average monthly income for the six months preceding your filing date against the median income for a same size household in your state.
If your income is less than the state median, you pass automatically. If your income is above median, you must use your expenses and allowed deductions to qualify. For most living expenses you are only allowed to deduct predetermined amounts (based on local and national IRS standards). But you can use your actual expenses for certain necessary deductions.
You Cannot Deduct Voluntary Retirement Contributions on the Means Test
The means test doesn’t allow debtors to use their voluntary retirement contributions to reduce their disposable income and qualify for Chapter 7 bankruptcy. When you voluntarily contribute to your retirement plan, it essentially means that you have extra income each month that you don’t need to spend on your necessary expenses.
Because Chapter 7 bankruptcy is primarily for debtors who have no disposable income to pay back their unsecured creditors, you can’t deduct your voluntary retirement contributions on the means test. If you could, many debtors would simply increase their monthly contributions just to pass the means test.
You Can Deduct Mandatory Retirement Contributions
If your employer requires you to make monthly payments to a retirement plan, you can deduct those amounts from your income on the means test to help you qualify for Chapter 7 bankruptcy. Because mandatory retirement contributions are a condition of your employment and not discretionary, the means test considers them a necessary expense you can use to reduce your disposable income.
What About Retirement Account Loan Payments?
Many debtors borrow from their retirement accounts when unexpected expenses come up. If you obtained a loan from your retirement account, you are likely making monthly payments to pay back the debt. But unfortunately, the Chapter 7 means test doesn’t consider retirement loan payments a necessary expense that you can deduct on the form.
This means that like voluntary retirement contributions, retirement loan payments can’t help you pass the means test and qualify for Chapter 7 bankruptcy. But if you wish to file for Chapter 13 bankruptcy, you can deduct your retirement loan payments to reduce the amount you have to pay unsecured creditors through your repayment plan (whether you can deduct voluntary retirement contributions in Chapter 13 bankruptcy depends on the rules in your jurisdiction and whether the monthly contributions are reasonable and necessary).