If you’re contemplating bankruptcy, you might feel like there are very few bright spots on the horizon. You can relax in at least one respect -- you’re probably not going to lose the retirement funds you and your employer have been paying into for years. Most retirement accounts, including 401(k)s, are exempt in bankruptcy.
Excluded Property is Safe
When you file for Chapter 7 bankruptcy, the assets you own form your bankruptcy estate. This property is available to the trustee so he can sell it to raise money to pay off as much of your debt as possible. But certain assets are excluded by law from the bankruptcy estate so the trustee can’t sell them. Retirement funds that are qualified under the Employee Retirement Income Security Act are excluded assets. Your 401(k) is an ERISA-qualified account if your employer contributed to it. Check with your employer to make sure this is the case. If it’s an ERISA plan, you don’t have to worry about losing it in bankruptcy.
Using Exemptions Can Protect Assets
If your 401(k) isn’t qualified under ERISA rules, so it’s part of your bankruptcy estate, all is not necessarily lost. You may still be able to protect it against liquidation. Individual states and the federal government allow debtors to apply exemptions to property they want to keep, effectively taking it out of the bankruptcy proceedings. Exemptions usually aren’t high-dollar -- for example, you might only be able to exempt $3,500 or so of your automobile’s fair market value -- but retirement funds are often an exception to this rule. Check with a local attorney to find out what exemptions are available in your state and whether they’ll be enough to protect your 401(k). Some jurisdictions limit debtors to using the state’s list of exemptions, while others let you choose between the federal list and what your state offers.
If You File for Chapter 13
If you file for Chapter 13 protection rather than Chapter 7, your 401(k) is safe. Chapter 13 is the plan where you pay off your debts over a period of years under the supervision of the court. Your property isn’t liquidated because your creditors receive payment from your disposable income -- what’s left over after you pay your necessary living expenses -- which you turn over to the trustee each month.
Avoid Cashing in the Account
Some debtors make the mistake of cashing in retirement benefits to try to avoid bankruptcy. If you’re thinking of doing this, speak with a lawyer first. If you end up having to file for bankruptcy anyway, you’ve parted with all that money and depleted your retirement funds unnecessarily -- the bankruptcy will ultimately discharge your debts. If you move the funds from your 401(k) to a bank account, they’re no longer protected against creditor collection efforts or liquidation in bankruptcy. If the money is in a bank account at the time you file for Chapter 7, the trustee can seize it. The court will generally leave you enough to meet your necessary support costs, however, if you’ve reached retirement age and need the funds for your basic living expenses. If you file for Chapter 13, the 401(k) funds can be included in your available income to pay off your debts through your repayment plan.
Moving money around just prior to filing for bankruptcy can also raise the specter of a possible fraudulent transfer. This might be the case if you did the reverse -- instead of cashing in your 401(k) to forestall bankruptcy, you might make significant contributions to your 401(k) before you file, knowing that the money will be protected. If you convert nonexempt assets into protected assets in an effort to prevent your creditors from receiving the money, the court can deny you a bankruptcy discharge.