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?

Fortunately, Congress saw the importance of having retirement savings – even if someone was filing for bankruptcy. In most cases, a 401(k) is protected. However, there are situations where your actions could put your retirement savings at risk. Transferring funds or taking out a 401(k) loan will impact your bankruptcy. Even adding funds to your 401(k) could cause an issue.

A successful bankruptcy requires planning. The work done before a case is filed is often more important than what occurs afterward. At Young, Marr, Mallis & Associates, our Philadelphia bankruptcy lawyers’ commitment to detail and experience are critical components that will help ensure you are receiving the most benefits from filing. It is also vital that you disclose all your retirement accounts so our office can address each appropriately. Call (609) 755-3115 in New Jersey or (215) 701-6519 in Pennsylvania today to start the process.

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.

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 similarto 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
  • 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 $1,362,800 per person. In other words, creditors are able to pursue any funds which are left over beyond this limit. Additionally, the $1,362,800 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.

401(k) Loans and Bankruptcy

When faced with overwhelming bills and financial difficulties, people will often turn to every possible means to alleviate their economic suffering. One option many turn to in order to catch up on their mortgage or pay credit card debt or medical bills is tapping into their retirement savings. If you take a 401(k) loan, you will be required to pay it back over a specific period of time to avoid a penalty. However, how are 401(k) payments treated in bankruptcy?

Chapter 7 Bankruptcy

One of the key calculations in a Chapter 7 bankruptcy case is deducting your necessary expenses from your disposable monthly income. Necessary expenses include rent or mortgage, utility bills, and grocery bills. However, most courts do not consider 401(k) loan repayments as a necessary expense. Therefore, you are not permitted to deduct your loan payments on the means test to qualify for Chapter 7. If you have disposable monthly income after deducting your reasonable monthly expenses, you will be required to file Chapter 13 – even if you are paying a significant 401(k) loan payment every month.

Chapter 13 Bankruptcy

However, and this might sound counter-intuitive, you are permitted to deduct the monthly amount you are contributing to a 401(k) loan repayment if you file for Chapter 13 bankruptcy. Therefore, you can continue to repay the money you borrowed from your 401(k) while you are in Chapter 13 bankruptcy. The remainder of your monthly disposable income, after deducting your reasonable monthly expenses and the 401(k) payment, will have to be used to pay your creditors.

The Chapter 13 trustee will want to know how long you have left on your 401(k) loan. If it will be paid off while in bankruptcy, the trustee will expect you to add the additional funds to your bankruptcy plan. For instance, imagine you are paying $200 on your 401(k) loan and $450 a month under your bankruptcy plan. However, you only have 24 months left on your loan payments and you filed a 60-month bankruptcy plan. The trustee will expect your $450 monthly payment to increase to $650 once you have repaid your 401(k) loan. This is known as a step-plan and will be filed by our Pennsylvania bankruptcy lawyers around the beginning of your case.

It might sound confusing that you are permitted to deduct your 401(k) repayment in Chapter 13 but not when you are attempting to qualify for a Chapter 7 bankruptcy. Unfortunately, the bankruptcy laws sometimes appear contradictory or confusing. This is one reason why it is crucial to have our experienced Pennsylvania bankruptcy lawyers handling your case.

Actions to Avoid if You Want to Protect Your 401(k) in Bankruptcy

As discussed above, you should be able to protect your 401(k) if you file for bankruptcy. However, there are things you could do that could jeopardize your retirement savings. For example, the funds are only protected if they remain in your 401(k) account. If you remove funds or transfer them into a non-exempt account, they lose the protection of the federal exemptions. You should not withdraw funds from your 401(k) account if you plan to file for bankruptcy.

Additionally, adding funds to your 401(k) before filing for bankruptcy could also cause a problem. If the trustee believes you were attempting to commit bankruptcy fraud by hiding assets in a 401(k) account while you were anticipating filing for bankruptcy, your 401(k) could lose its exempt status. The trustee would have to file a motion with the court and convince the bankruptcy judge that you were attempting to interfere with the bankruptcy process or defraud your creditors. Before making any moves with your 401(k), you should speak with one of our knowledgeable Pennsylvania bankruptcy lawyers.

Using Your 401(k) to Pay Down Debt Before Filing for Bankruptcy

As stated above, it is not a good idea to move funds from your 401(k) to another non-exempt account if you plan to file for bankruptcy. However, is it a good idea to draw on your 401(k) savings to pay down existing debts before you file?

The answer is probably no, especially if you cannot completely pay back all of your debt. The funds in your 401(k) account are protected from your creditors and the trustee. If you are considering filing for bankruptcy, you could be taking a loan or withdrawing funds to pay back debt that would be discharged. Additionally, as seen above, having a 401(k) loan repayment could jeopardize your ability to qualify for Chapter 7 or require a step-plan if you file for Chapter 13.

What you used the loan for could also be a problem. If you took a 401(k) loan to pay a specific creditor or loan before filing for bankruptcy, the trustee could void the payment to distribute the funds amongst all your creditors. While this might not be an issue if you paid a credit card or personal loan, it could present a problem if you paid back a family member or close friend. Also, if you had a 401(k) loan and paid it off before filing for bankruptcy, the trustee could undo the transfer of funds to your retirement account. Essentially, repaying a 401(k) loan is repaying yourself before you pay your creditors.

The key to any successful bankruptcy is understanding your options and making informed decisions based on your circumstances. The best way to avoid making critical mistakes is to speak with one of our Pennsylvania bankruptcy attorneys before you take any actions that could jeopardize your retirement savings.

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, Mallis & Associates at (609) 755-3115 in New Jersey or (215) 701-6519 in Pennsylvania today. We serve the residents of New Jersey and Pennsylvania.

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