Can You Use Retirement Funds to Avoid Bankruptcy?
If you are facing financial challenges, you might be searching for different ways that you can get out of debt and avoid bankruptcy. One potential consideration might be dipping into your retirement funds to pay off outstanding debt in one lump sum.
While this might sound like a good idea on the surface, it’s not always advisable. There are many reasons for this.
For one, if you withdraw funds from many tax-advantaged retirement accounts, you may face a penalty of 10% plus the fact that you’ll have to claim these funds as income. Doing so may also deplete your retirement savings.
What’s more, many retirement accounts such as 401(k)s and IRAs, are generally protected in bankruptcy proceedings and while they are considered part of the bankruptcy estate, they are generally 100% exempted and thus not recoverable by creditors or the Bankruptcy Trustee. As such, U.S. Bankruptcy Courts won’t force you to drain your retirement funds as you march toward debt relief.
Retirement funds are considered “protected assets” under bankruptcy laws, which means you can file bankruptcy without impacting your retirement accounts.
This is why filing bankruptcy may be the better choice.
What are Exemption Limits for IRAs?
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which was passed in 2005, protects both Traditional and Roth IRAs in bankruptcy proceedings. Each person has a protected limit of $1,512,350 that they can have in these accounts.
This limitation applies to all of the combined holdings that you have in all of your IRAs, not to each individual IRA that you may have. This means that if you have more than this combined in your IRA accounts, the surplus could be used to help repay your creditors.
The federal government adjusts this exemption limit every three years to account for rising cost of living.
Which Retirement Accounts Aren’t Protected?
It’s important to understand that only money that is stored in an officially designated retirement account is protected under U.S. bankruptcy laws. Any money that you store in regular savings accounts, stock option plans, investment accounts or any other non-retirement bank or brokerage account generally isn’t protected from bankruptcy — even if those funds are going to contribute to your retirement.
As such, any money that is stored in these accounts can be considered as part of your bankruptcy estate, which can then be used to pay off creditors. The only way for this money to be kept separate is to obtain a separate cash exemption, which may not be possible.
How Retirement Income is Treated in Bankruptcy?
What happens if you have already retired and are collecting retirement benefits, though? In this case, your retirement benefits are considered income.
Like other income, these retirement benefits can be used by the bankruptcy court to determine whether you’re able to repay your debts. How this retirement income is treated, though, depends on the type of bankruptcy that you are filing, as we’ll discuss below.
Chapter 7 Bankruptcy and Retirement Income
Chapter 7 bankruptcy is considered a liquidation bankruptcy. The end result is to have certain debts discharged at the end of the proceeding so that you can get a fresh start financially, while the Chapter 7 Trustee will seek to sell and turn into cash any unexempt, (e.g., unprotected) assets of the bankruptcy estate.
To be eligible for Chapter 7 bankruptcy, you have to have an income level that’s considered below the median for the state in which you live, as determined by the Chapter 7 means test. The test will take into account your secured debts and other expenses, along with your income.
The courts will also look to see how much monthly income you have remaining at the end of month after receiving your monthly income and spending it on your normal everyday living expenses. If you have some money left over at the end of the month, then you may not be eligible for a chapter 7 case.
In this process, the bankruptcy court has the ability to consider monthly retirement benefits that you are receiving through retirement accounts and pensions. Any retirement benefits that are ultimately considered to be above and beyond what’s needed to support your life can be used to repay your creditors.
Chapter 13 Bankruptcy and Retirement Income
Chapter 13 bankruptcy, meanwhile, is considered a restructuring. The goal is to restructure your overall debt and come up with a repayment plan that satisfies you and your creditors, while also preserving your major assets.
In these cases, the court will use your income to determine how the debts will be repaid and how much of them you will be required to pay. Typically, the payment plans are set up to last about three to five years.
Any retirement benefits that you receive can be factored into the equation, which could potentially increase the total amount of debt you’re responsible for repaying.
Using Retirement Accounts to Avoid Filing Bankruptcy
If you have significant retirement funds, you may think it’s a good idea to use them to avoid bankruptcy altogether. However, as stated above, this might not be a good idea depending on your situation.
For instance, if you are younger than retirement age, withdrawing funds from these accounts can come with hefty penalties, fees and taxes. You’ll be responsible for paying a 10% penalty on all the money you withdraw, plus that money will be considered income for tax purposes..
Since bankruptcy laws consider money in retirement accounts as “protected assets,” you can file bankruptcy without any impact to what you’re built in your retirement accounts.
Borrowing from Your 401(k) to Avoid Bankruptcy
In some cases, you can avoid these hefty penalties, fees and taxes by borrowing from your 401(k). Generally speaking, doing so to avoid filing for bankruptcy is not usually a good idea.
The reason for this is that you will be required to repay these funds according to a strict schedule. While the interest you pay will benefit you rather than a creditor, it’s essentially just shifting around debt rather than paying it off. Plus, if you aren’t able to repay the debt, or if you lose your job, you may ultimately have to claim all the borrowed money as income and pay a hefty penalty.
An experienced bankruptcy attorney such as those at Babi Legal Group can help you assess your finances to determine whether bankruptcy is a better option than borrowing from your 401(k).
Withdrawing Retirement Funds to Pay Creditors
Usually, withdrawing retirement funds outright to pay off your creditors is not a good option, either. This can actually lead to more debt, tax liability and extra financial stress, rather than solving any problems.
That’s because bankruptcy protection allows you to get rid of debt and debt collectors while preserving retirement accounts.
Protecting Your Retirement Funds in Bankruptcy
In general, ERISA-qualified retirement funds and balances in both Traditional and Roth IRAs are protected from creditors during bankruptcy. There are limitations, of course, and rules that you must consider when filing for bankruptcy to protect these accounts.
Fully Protected Retirement Accounts
Pension plans that are considered ERISA-qualified are also fully protected during bankruptcy proceedings. Unlike IRAs, there are also no limits on the amount that will be exempted.
At the same time, any plan or account that isn’t ERISA-qualified — including stock options, investment accounts and general savings accounts — don’t enjoy bankruptcy protections. Only a few states have local exemptions that will protect these accounts, and even those states only provide minimal exemptions.
Bankruptcy and Retirement Planning
While filing for bankruptcy could be affected by the retirement benefits you receive, it will generally provide protection for funds in your 401(k), IRA, pension and other plans.
Withdrawing money from these accounts usually comes with major tax penalties, and doing so may not even fix your financial problems. Since most unsecured debts such as balances on credit cards and medical bills can be eliminated through bankruptcy, and retirement funds are protected, bankruptcy is sometimes the better option.
Because of this protection, bankruptcy can allow you to get rid of your debt and debt collectors while preserving the money you have in your retirement accounts.
Bankruptcy Lawyers Can Help
Filing for bankruptcy is often the better option than drawing on retirement assets to pay off debts. Having a knowledgeable bankruptcy attorney on your side is invaluable, as they can provide you expert advice and assistance on how to best navigate bankruptcy without affecting your retirement funds.
Not only can these attorneys guide you through the process, they can help you understand all applicable federal and local laws. This is very important, as these laws are often extremely hard to understand.
Before you file for bankruptcy, consult with a local bankruptcy attorney that you can trust.
The attorneys at Babi Legal Group have more than 15 years of experience in bankruptcy, debt settlement and debt collection law. We can help you review all of your financial information to guide you through the bankruptcy process and protect your retirement funds in the process.
For more information, please contact us today.
