Retirement accounts are almost always protected in a bankruptcy case. If you are 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 December 28, 2020
Ready for some good news? Retirement accounts are almost always protected in a bankruptcy case. So if you are seriously considering filing a bankruptcy case, keep your retirement assets where they are in order to best protect them.
Even if you can pay off all your debts with money from your retirement, it is probably still not a good idea.
Unless you can fully pay off all of your debts, taking money out of your retirement accounts to keep up with payments usually only prolongs the inevitable. You will likely lose a significant portion of the value to tax penalties and fees for early withdrawal. Plus, you’ve lost out on retirement savings you likely could have kept and used toward your financial future.
If you find yourself considering bankruptcy, your debts will be discharged. Protecting your retirement accounts will go a long way toward ensuring that you will not face this situation again.
As with everything in law nothing is absolutely guaranteed, but below we will discuss some of the most common types of retirement investment accounts and how bankruptcy can affect them.
What are the different types of bankruptcies?
When we talk about personal bankruptcy cases we are generally referring to Chapter 7 and Chapter 13.
A Chapter 7 case is a “total liquidation” bankruptcy, where at the successful conclusion of the case most, if not all, of your debts are discharged. This means that any expensive property is sold off to pay your debts and any eligible debts that remain get erased.
A Chapter 13 case, in contrast, involves paying back a percentage of your debts through a three to five year repayment plan. This is usually based on a number of factors including your income and types of debt.
Although your retirement income is a factor in either a Chapter 7 or a Chapter 13 case, this article will primarily focus on what occurs during Chapter 7.
What does it mean to say a retirement account is “protected?”
During a Chapter 7, if there is anything of value, the Chapter 7 Trustee has the right to seize valuable property, sell it, and use the proceeds from the sale to pay back some money to your creditors.
Assets that are “protected” are yours to keep and will not be taken to sell off your debts.
What if I am receiving income from my retirement accounts?
You will need to take your retirement income into consideration whether you file for Chapter 7 or Chapter 13.
If you are 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 retirement payments and/or Social Security payments as their only income will still qualify to file a Chapter 7 bankruptcy.
Your retirement income vs. you 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 are not considered income and do not go into the means test calculation.
What types of retirement accounts are always protected in a bankruptcy?
Not everything is at risk in a bankruptcy case. Some assets are excluded from ever being considered part of the bankruptcy estate, while other assets are considered exempt.
If property is “excluded,” it means that it is 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 will 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 is protected from being sold by the Trustee.
Below we will examine the specific types of retirement accounts that generally protected during bankruptcy.
ERISA-qualified plans Congress changed the Bankruptcy Code in 2005 and declared that any retirement account that falls under the Employee Retirement Income Security Act (“ERISA”) as an “ERISA-qualified pension plan” is fully protected and will be completely excluded from the bankruptcy estate. These accounts include:
IRAs (Roth, SEP, and SIMPLE but see limitations discussed below)
money purchase plans, and
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 are older if you do not have enough retirement savings to support yourself after you stop working.
IRAs and Roth IRAs Although IRAs and Roth IRAs generally qualify under ERISA, there are a few ways that they differ from other accounts.
There is a cap on how much you can be protected in an bankruptcy case, which currently limited to $1,283,025 per person.
Keep in mind this limit refers to all of your IRA accounts combined, not per each account. That said, most people are not fortunate enough to come anywhere near that limit in their personal retirement savings.
What about plans that are not ERISA-qualified?
It is also important to note that general savings accounts, investment accounts and stock option plans are not protected if they are not “ERISA-qualified” plans. Knowing what type of retirement accounts you have prior to filing will avoid any unpleasant surprises.
Again, most traditional retirement accounts offered by employers will fall under the ERISA-qualified umbrella and be protected in full. It is usually only a potential issue when you start getting into more advanced retirement-planning.
Can my retirement account protection be lost?
Yes, there are some situations that can put your retirement account at risk.
Retirement accounts are only protected if it used as an account for later on. So, if you have taken money out of your retirement account recently, it might not continue to be protected.
In some cases, this money is distributed.
This money would be seen as a part of your eligible “bankruptcy estate.” The Trustee could sell it to repay your creditors.
Penalties for Early Withdrawal
Any time you are taking funds out of a retirement account prior to your age of retirement, these disbursements are subject to penalties which can be significant.
For many qualified retirement accounts it is not uncommon to incur 10% penalty for an early withdrawal, and the funds will be taxed as gross income if you withdraw before the minimum age. Remember that one of the main benefits to retirement accounts is that they allow you to contribute money before it is taxed. So long as you do not remove the funds prior to the allowable age, you can utilize all the funds.
Withdrawing funds early can significantly reduce the amount of value in 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.
Money that is withdrawn from a retirement account and paid to just one creditor right before a bankruptcy is filed can be seen as a “preferential transfer” and the Chapter 7 Trustee can void the transfer.
An example of a preferential transfer would be in a case where you took money out of your retirement account to pay off a particularly aggressive creditor. Perhaps someone was threatening a lawsuit or maybe you repaid a loan to a friend or family member, in both circumstances repaying only a single debt.
Preferential transfers are problematic because you are not treating your creditors equally and choosing to pay one over the others. As a result of this, the Chapter 7 Trustee can void the payment which 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, 6 months, a year or even two years prior to your filing.
So, if you did make a payment that might be seen as preferential it could end up delaying when you file your case. If you file too early, the payment could be seen as preferential. If so, the Trustee could void the transfer and instead bring that money into the bankruptcy estate.
Your 401K is usually protected during bankruptcy although there are things you can do to put it at risk
In almost all circumstances your exempt retirement accounts are completely protected when filing a bankruptcy.
Although it may feel necessary, dipping into your 401 to keep creditors at bay can come at a significant cost. More often than not, it will only help you delay the inevitable when dealing with your debt problems.
Filing for a Chapter 7 bankruptcy should allow you to get a fresh start, which includes protecting your retirement plans to that you can go onto to a stable financial future.