Will Bankruptcy Affect My 401(k)?

A 401(k) is an employer-sponsored retirement plan which lets employees put aside retirement savings without being taxed until they withdraw money from the account.  In the United States, the average 401(k) contains about $89,000 in funds — a considerable chunk of money.  But is how is that money treated during bankruptcy? What happens to your 401(k) account if you decide to file for Chapter 7 or Chapter 13?  Our Pennsylvania bankruptcy lawyers explain the exemptions and protections surrounding debtors’ 401(k) accounts — and whether or not they can be accessed by your creditors.

Are 401(k) Plans Exempt from Creditors in Bankruptcy?

It’s a common misconception that when you file for bankruptcy, you automatically lose your car, all of your belongings, and your home.  This is an exaggerated, fear-mongering image which does not often depict reality. It’s true that when a debtor files for bankruptcy, some of his or her income, assets, and possessions are subject to reclamation by creditors — but there are also many assets which can be protected by state or federal exemptions, particularly if a debtor is proactive and starts addressing their financial issues early.

Financial - Will Bankruptcy Affect My 401(k)?

While some states are more restrictive and do not offer this option, Pennsylvania and New Jersey debtors are fortunate in that they may choose freely between utilizing the federal or state exemptions. (However, this is a strictly either-or situation: debtors cannot mix and match individual exemptions from both sets.)  New Jersey, Pennsylvania, and the federal government all permit debtors to exempt their tax-exempt retirement plans, including 401(k) accounts.

Better still, unlike other exemptions which are subject to financial caps (such as Pennsylvania’s $300 cap on the wildcard exemption, or New Jersey’s $500 monthly cap on annuity benefits), the exemption amounts on retirement funds are — in all but a few cases — unlimited.  This means you can protect the full amount, and not just a certain portion or percentage.

Retirement Plans That ERISA Protects

Retirement plans such as 401(k)s enjoy this generous protection largely due to a federal law from 1974 called ERISA, which stands for the Employee Retirement Income Security Act.  In addition to shielding 401(k) savings from being accessed by creditors, ERISA also protects a variety of other retirement plans, such as:

  • 403(b)s — Lesser known than its cousin, the 403(b) — also known as a TSA or tax-sheltered annuity plan — is similar to a 401(k), but is meant for employees of tax-exempt nonprofit organizations like churches and schools.  In contrast, 401(k) plans are offered by for-profit companies.
  • Defined Benefit Plans — The formal name for a traditional pension.  Unlike defined contribution plans, which include 401(k)s, defined benefit plans involve automatic payments which depend on the amount of time the employee has been working.
  • Keogh Plans — A Keogh plan is a type of pension meant for unincorporated businesses and self-employed individuals (i.e. sole proprietorships). Keogh plans can be structured as defined benefit or defined contribution plans.
  • Money Purchase Plans — Money purchase plans are defined contribution plans, like 401(k)s. With a money purchase plan, the employer must make a “defined” yearly “contribution.”
  • Profit-Sharing Plans — These are often confused with money purchase plans.  The difference is that with a profit-sharing plan, contributions are allocated to separate accounts for the participating employees.

Special Bankruptcy Exemption Rules for IRAs and Roth IRAs

While 401(k)s and other retirement savings plans enjoy uncapped protection against creditors in most bankruptcy cases, traditional IRAs (Individual Retirement Accounts) and Roth IRAs are subject to a limit of $1,245,475 per person.  In other words, creditors are able to pursue any funds which are left over beyond this limit.  Additionally, the $1,245,475 limit applies to your combined plans — not each individual plan.

It is very important to point out that in June of 2014, the U.S. Supreme Court ruled that inherited IRA funds were not considered to be retirement funds in the true sense.  As a result of this critical ruling, any IRA funds which you inherit from a relative are not considered to be exempt from collection by creditors in bankruptcy.

Interestingly, the term “retirement funds” is not specifically defined anywhere in the U.S. Bankruptcy Code. Supreme Court Justice Sonia Sotomayor noted that in the traditional sense, retirement funds are typically defined as “sums of money set aside for the day an individual stops working,” and that this definition may not necessarily apply to inherited IRAs, which could theoretically be withdrawn and used for anything, and not retirement purposes exclusively.

Call Our Pennsylvania Bankruptcy Lawyers Today

If you are thinking about filing for Chapter 7 or Chapter 13 bankruptcy, it is prudent to consult with a legal representative who can help you make advantageous and strategic financial decisions.  To arrange for a free and confidential consultation, call the Philadelphia bankruptcy attorneys of Young, Marr & Associates at (609) 755-3115 in New Jersey or (215) 701-6519 in Pennsylvania today.  We serve the residents of New Jersey and Pennsylvania.