If you file for Chapter 7 or Chapter 13 bankruptcy, what happens to your 401(k) account? For the most part, your 401(k) and other qualified retirement accounts (such as 403(b)s, profit-sharing and money purchase plans, IRAs, and defined-benefit plans) are safe -- you won't lose them in the bankruptcy. Because federal law protects these accounts from creditors and the bankruptcy trustee, cashing in a 401(k) to deal with debt is almost always a bad idea.
Here's how the law works.
Chapter 7 vs. Chapter 13 Bankruptcy
There are two main chapters of bankruptcy used by consumers: Chapter 7 and Chapter 13.
In Chapter 7 bankruptcy, you eliminate most or all of your debt, but in return must turn over nonexempt property to the bankruptcy trustee, who sells it and uses the proceeds to pay your creditors. Any property that is exempt through state or federal law is protected, and cannot be taken by the bankruptcy trustee.
In Chapter 13 bankruptcy, you keep your property and pay off some or all of your debts through a three to five year repayment plan.
There are a variety of other significant differences between Chapter 7 and Chapter 13 bankruptcy, and not everyone is permitted to file for Chapter 7.
How Chapter 7 and Chapter 13 Bankruptcy Impact Your 401(k)
Despite the differences between Chapter 7 and Chapter 13 bankruptcy, the impact on your 401(k) is the same in both chapters -- you get to keep it. Here's why.
Chapter 7: Federal Law Exempts 401(k)s and Other Tax-Exempt Accounts
Under federal law, almost all types of tax-exempt retirement accounts are exempt in bankruptcy, regardless of whether you are using state or federal bankruptcy exemptions. (To learn more about bankruptcy exemptions and how they work, see Bankruptcy Exemptions -- What Do I Keep When I File for Bankruptcy?) This includes 401(k)s, 403(b)s, profit-sharing and money purchase plans, IRAs, and defined-benefit plans. With one exception, the exemption amount is unlimited -- which means you can exempt the entire amount in the account. The exception applies to traditional and Roth IRAs -- those accounts are exempt up to a combined total of $1,171,650.
Chapter 13: Retirement Accounts Are Safe
Because you get to keep your property in Chapter 13 bankruptcy, your 401(k), IRAs, and other tax-exempt retirement accounts are safe.
What Not to Do With Your 401(k)
The fact that a 401(k) is protected during bankruptcy means people can file without jeopardizing their retirement. As such, it is important to understand a few things you should not do with your 401(k) or other tax-exempt retirement accounts when thinking about bankruptcy:
- Don't Cash in the 401(k): As soon as you take the money out of the 401(k) and put it into another type of account (perhaps because you wanted to use the money to pay bills), the 401(k) loses its exempt status.
- Don't Use the 401(k) to Prolong the Inevitable: Some people cash in their 401(k) in order to use the money to get their finances back on track. This is almost always a bad idea. Not only will you pay penalties for withdrawing your 401(k) funds early, but you essentially use exempt assets to pay debts that might be discharged in bankruptcy anyway. If you end up filing for bankruptcy, it's better to do so with your retirement savings safe in the bank.
- Don't Move a Lot of Money Shortly Before Declaring Bankruptcy: Some people might think it's a good idea to convert nonexempt assets, like money in a regular savings account, into exempt assets by making a large contribution to a retirement account shortly before declaring bankruptcy. Don't do this without talking to a bankruptcy lawyer first. If the trustee believes you transferred property in order to hinder, delay, defraud, or shortchange a creditor, you may lose the exempt status of the property. Worse case scenario: If the court believes you engaged in fraud, it can refuse to grant you the bankruptcy discharge.