Is a 401(k) protected from bankruptcy?

How bankruptcy affects your 401(k)

During bankruptcy, a court liquidates your assets. Although some assets are subject to forfeiture, this does not generally affect your 401(k), regardless of whether you file Chapter 7 or Chapter 13 bankruptcy. The Employee Retirement Income Security Act (ERISA) provides protections for retirement accounts, holding 401(k)s mostly exempt from bankruptcy proceedings as long as the funds are not withdrawn.

This is because your 401(k) is not a liquid account, and there are requirements in place regarding when withdrawals can be made. Funds generally are unavailable until a certain age, keeping them safe from creditors. However, you may not be able to continue 401(k) contributions under Chapter 13 bankruptcy until your repayment plan is concluded. State laws can vary, so it is always best to consult a bankruptcy attorney for information about your specific case.

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Protections for retirement accounts

Bankruptcy is handled in different ways. With Chapter 7 bankruptcy, you typically forfeit your assets for liquidation. Chapter 13 focuses on a repayment plan. The ERISA considers defined contribution plans, such as a 401(k), to be an exempt asset in both types of bankruptcy. The exemption includes several types of retirement plans, including:

• Traditional 401(k)s
• SIMPLE 401(k)s
• Safe harbor 401(k)s
• Automatic enrollment 401(k)s
• 403(b)s
• Roth IRAs
• SEP IRAs
• SIMPLE IRAs

Some profit-sharing and defined benefit plans may also qualify for protection, depending on how they’re structured. However, other accounts, like your savings accounts and investments, are not protected under the ERISA and may still be subject to liquidation.

When your 401(k) can be taken

There are some times when your 401(k) may be vulnerable to creditors. If you are not taking distributions, your 401(k) is usually safe unless you fall under one of these three exceptions.

• Unpaid income tax: If you have unpaid federal income tax, the IRS may use your 401(k) to pay the balance. However, state and property taxes do not typically affect your 401(k).
• Unpaid child support or alimony: Just like your Social Security benefits, a court can order that you withdraw from your 401(k) to pay outstanding child support or alimony.
• Criminal penalties: If you have unpaid federal criminal fines or penalties, you may have to turn over your 401(k) to resolve the debt.

If you meet one of these conditions, it is best to consult with an attorney on the next steps. If you are already taking distributions, those funds could be subject to forfeiture during bankruptcy. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) stipulates that disposable income includes retirement income for both Chapter 7 and Chapter 13 as long as specific thresholds are met.

Pro tip

Even though it’s protected, withdrawing from your 401(k) to pay debts before filing for bankruptcy is usually not recommended. You could lose valuable retirement savings and still end up needing to file.

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Understanding reaffirmation agreements

A reaffirmation agreement is a legal agreement made during bankruptcy between a debtor and a lender. It allows the debtor to keep collateral, such as a home or car, if they promise to repay all or a portion of the debt. How much you pay depends on the terms you negotiate with your lender.

Reaffirmation agreements are common during Chapter 7 bankruptcy.

To enter into a reaffirmation agreement, you must first provide the court with a statement of intent. Then, you must contact your lender to work out an agreement to repay the debt.

One of the key benefits of a reaffirmation agreement is that credit reporting agencies are notified. This means you can use your payments to fix your credit after bankruptcy so you can get a personal loan or mortgage in the future.

How to pay off debt without your 401(k)

It is not an ideal solution to use your 401(k) to pay off debt. There are typically penalties that apply if you withdraw from your plan before age 59½. However, your 401(k) is not your only solution. You can pay off debt in other ways, such as these.

• Consider a debt payoff method: The debt avalanche and snowball methods are popular. With the debt avalanche method, you pay off debts starting with the highest interest rate first and moving down the line. The debt snowball method begins with the smallest debt first and works up to the larger debts.
• Debt consolidation loan: A debt consolidation loan lets you combine your debts into one loan with a single monthly payment. If the interest rate is lower than the loans you already have, you can save money on interest.
• Work with a credit counselor: A credit counseling service can work with you to develop a debt management plan. It can also help you create a budget and teach you how to manage your money so you can avoid debt in the future.
• Use home equity: A home equity loan or home equity line of credit (HELOC) can give you access to extra cash that you can use to pay off debt. Be aware that this will use your house as collateral, so you could lose your home if you default.

A bankruptcy attorney can advise on current state and federal laws so you know how to move forward while protecting your 401(k) plan.

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