Retirement accounts are almost always protected in a bankruptcy case. If you're considering filing, it’s best to keep your retirement assets where they are. Unless you can fully pay off all of your debts, taking money out of your retirement accounts to keep up usually only prolongs the inevitable.
Written by Attorney Eva Bacevice.
Updated January 26, 2022
Ready for some good news? Retirement accounts are almost always protected in a bankruptcy case. When you're struggling financially, you may be tempted to dip into your retirement funds, but if you're seriously considering filing a bankruptcy case, keep your retirement assets where they are to best protect them.
Even if you can pay off all your debts with money from your retirement, it's probably not a good idea if it leaves you with nothing to live on in retirement. Plus, you'll face tax penalties and fees for withdrawing retirement funds really, and you'll lose out on retirement savings you likely could've kept and used toward your financial future.
If you file bankruptcy, your debts will be discharged. Protecting your retirement accounts will go a long way toward ensuring that you won't face this situation again. As with everything in law, nothing is absolutely guaranteed. But below, we'll discuss some of the most common types of retirement investment accounts and how bankruptcy can affect them.
What Does It Mean To Say a Retirement Account Is “Protected”?
In a Chapter 7 bankruptcy, if you own valuable property or assets, the Chapter 7 trustee has the right to seize it, sell it, and use the proceeds from the sale to pay back some money to your creditors.
Assets that are protected by an exemption are yours to keep and will not be taken to sell off your debts.
What if I'm Receiving Income From My Retirement Accounts?
You'll need to take your retirement income into consideration whether you file for Chapter 7 or Chapter 13 bankruptcy. If you're already receiving your retirement income, you’ll need to consider that amount when determining your eligibility for Chapter 7. Retirement income will also be calculated into the payment for a Chapter 13 plan.
Generally speaking, people who are relying on only retirement payments and/or Social Security payments as their only income will qualify to file a Chapter 7 bankruptcy.
Retirement Income vs. Social Security Income
It’s important to note that retirement income is treated differently than your Social Security benefits. Unlike your retirement income, your Social Security benefits aren't considered income and do not go into the means test calculation.
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What Types of Retirement Accounts Are Always Protected in a Bankruptcy?
If property is “excluded,” it means that it's not eligible to be considered (or potentially sold off) during your case. If property is “exempt,” it means that the type of property is usually considered during your case, but there are laws that allow you to protect up to a certain amount of it.
You'll need to check both your state’s bankruptcy exemptions and the federal bankruptcy exemptions. Although they don’t always choose to do so, states are permitted to offer their own exemptions, which can differ from the federal ones. In those instances (depending on the state), you can decide which you would prefer to file under.
When an asset is excluded or properly exempted in a bankruptcy filing, it's protected from being sold by the trustee.
Below we'll examine the specific types of retirement accounts that are generally protected during bankruptcy.
Congress changed the Bankruptcy Code in 2005 and declared that any ERISA-qualified pension plan is fully protected and will be completely excluded from the bankruptcy estate. ERISA stands for the Employee Retirement Income Security Act, a federal law.
These accounts include:
IRAs (Roth, SEP, and SIMPLE, but see limitations discussed below)
Money purchase plans
When you think it through, the reasoning here makes sense: If filing a bankruptcy forced you to lose any retirement savings to pay off creditors, then it would not truly offer a fresh start. You would likely end up in financial trouble again when you're older if you don't have enough retirement savings to support yourself after you stop working.
IRAs and Roth IRAs
Although IRAs and Roth IRAs generally qualify under ERISA, they differ from other accounts in a few ways. There's a cap on how much you can protect in a bankruptcy case, which is currently limited to $1,362,800. Keep in mind this limit is for all of your IRA accounts combined, not each account. That said, most people aren't fortunate enough to come anywhere near that limit in their personal retirement savings.
What About Plans That Aren't ERISA-Qualified?
General savings accounts, investment accounts, and stock option plans aren't protected if they're not ERISA-qualified plans. Knowing what type of retirement accounts you have before you file your bankruptcy case can help avoid any unpleasant surprises. Again, most traditional retirement accounts offered by employers will fall under the ERISA-qualified umbrella and be fully protected.
Can My Retirement Account Protection Be Lost?
Yes, some situations can put your retirement account at risk.
Retirement accounts are only protected if they're used as an account for later on. So, if you've taken money out of your retirement account recently, it might not continue to be protected. If your trustee views this money as part of your eligible bankruptcy estate, they can distribute it to your creditors. This will depend on the amount you withdrew and whether you used it for basic living expenses or something else.
Penalties for Early Withdrawal
Any time you take funds out of a retirement account before you've retired or are of retirement age, you'll be subject to penalties. These can be significant.
It's not uncommon to incur a 10% penalty for an early withdrawal, and the funds will be taxed as gross income if you withdraw before you reach the minimum retirement age. Remember that one of the main benefits of retirement accounts is that they allow you to contribute money before it's taxed.
Withdrawing funds early can significantly reduce the value of your retirement account. Money that just sits there is protected and will continue to grow. Money that is removed is reduced by fines and loses its protected status.
If you withdraw money from a retirement account and pay it to just one creditor right before filing bankruptcy, this may be seen as a preferential transfer. For example, maybe you took money out of your retirement account to pay off an aggressive creditor. Or maybe you repaid a loan to a friend or family member.
Preferential transfers are problematic because you're not treating your creditors equally. As a result of this, the Chapter 7 trustee can void the payment. This means they can demand that the money be refunded to your estate to potentially be distributed equally.
Preferential transfers occur within a certain time frame leading up to filing your case. Depending on the type of repayment, the amount of time can range from 90 days to one year prior to filing.
In almost all circumstances, your exempt retirement accounts are completely protected when filing a bankruptcy. Although it may feel necessary, dipping into your 401(k) to keep creditors at bay can come at a high cost. More often than not, it will only help you delay the inevitable when dealing with your debt problems.
Filing Chapter 7 bankruptcy should allow you to get a fresh start, which includes protecting your retirement plans so that you can have a stable financial future.