Retirement accounts are safe in bankruptcy court

Senior couple on boat with mountains in background taking Savings for retirement, in the form of 401(k), IRA, and other government sponsored savings accounts, are for most people their most precious financial asset. That is why the bankruptcy laws give special protection to these savings accounts.   Last month the stock markets took us through a painful roller coaster ride.  But the pain of watching accounts go up and down in an uncertain market can’t be matched to the pain of having to withdraw these dollars to pay a creditor.  Bankruptcy attorneys like myself always cringe when we consult with a prospective client who informs us that they have already spent their retirement accounts to keep their creditors away.  This is almost always a temporary fix and leaves this person facing the reality that was there all along – the need to discharge unmanageable debt with a bankruptcy to get a fresh start with finances.   Whether filing under chapter 7 or chapter 13 of the bankruptcy code,  retirement assets in these special accounts are almost always exempt from creditors and therefore protected from surrender to the bankruptcy court.  Yes, you can go through a bankruptcy and keep your retirement assets, no matter how high the balance in your retirement account.

A person considering withdrawing money from a retirement account needs to consider several points.  First,  taking the money out actually creates a new debt: taxes and penalties that are owed to the IRS.  Withdrawing money from a retirement account before the elgible age (59 1/2) results in an early withdrawal penalty of 10%. This must be paid during the tax year of the withdrawal.  In addition to the penalty, the money withdrawn is taxed as income.  This means that the money you take out is reduced immediately by what you owe to the IRS for withdrawing it: a total of 30 – 40% depending on your tax bracket. Worse, that tax debt, in most circumstances, cannot be discharged in bankruptcy.  So paying creditors with retirement savings creates a new debt that may not be dischargeable in bankruptcy.

Second, unless you are able to take out enough money to satisfy all of your creditors, it is likely that this plan will fail.  Eliminating the harassment of a single creditor with a withdrawal from your retirement account will still leave you dealing with other creditors who want to be paid.  What have you accomplished by reducing your retirement assets if the remaining debt is not addressed?

Third, because the law doesn’t allow your creditors to take your retirement assets, even in bankruptcy, you are giving them something that they are not legally entitled to.  Has this creditor ever reciprocated with a similar act of generosity?  Is the creditor forgiving a portion of the balance in return for your generous contribution? I see this most often with the holders of second mortgage liens that are chasing the deficiency after a short sale or deed in lieu transaction.  If you have retirement assets, they are unlikely to release you and they will chase you into court hoping that you cave in at the last minute to pay them your hard saved retirement dollars.

Some purists might say that you should never, ever, ever, ever, no matter what, make an early withdrawal from a retirement account.  I’m not willing to go that far – there are extenuating situations that might justify having to access this money  (there are actually circumstances in which the early withdrawal penalties are excused).  But using these precious dollars to pay a creditor is almost always a bad decision.  Discharging unmanagable debt in bankrutpcy affords an individual or family the right to hold on to long saved dollars to secure a future when earnings may not come as easily.  If you are considering liquidating your retirement assets to pay creditors, please first consider consulting with a bankrutpcy attorney to see if there is a better way to resolve your debts.  I offer a free consultation for individuals and families who want to find out if bankruptcy is a good solution for their financial situation.


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