When individuals find themselves in financial distress, they often consider whether to file for bankruptcy. In that situation, it is common to be concerned about losing assets. A particular worry is: how does bankruptcy affect retirement planning? Will you be able to keep your retirement benefits, you worked so hard to obtain? Some retirement benefits are protected, depending on how you handle them.
Cashing out before filing for bankruptcy
Actually, cashing out your retirement account before filing for bankruptcy is not the best idea. Believe it or not, retirement accounts have some of the broadest protections from creditors in bankruptcy. That is because they are normally either exempt or excluded from the bankruptcy estate altogether. The other reason you should not cash out your retirement accounts, is that there are severe penalties and negative tax consequences if you do so too early.
Qualified retirement plans are often exempt from bankruptcy
Under certain circumstances, debtors in bankruptcy are allowed to retain benefits from certain qualified retirement plans.” The United States Bankruptcy Code defines a “qualified retirement plan” as follows:
any money or assets, payable to a participant or beneficiary from, or any interest of any participant or beneficiary in, a retirement plan or profit-sharing plan that is qualified under Section 401(a), 403(a), 403(b), 408, 408A or 409 of the Internal Revenue Code of 1986, as amended, except as provided in this paragraph.
So, what does this mean? Essentially, the most common “qualified retirement plans” include profit sharing plans (including 401(k) plans), defined benefit plans, and money purchase pension plans. Generally, these are plans in which your contributions are not taxed until you withdraw money from the plan. That is the characteristic that makes them exempt.
ERISA Protections for 401(k) contributions
Another important thing to know is that a bankruptcy trustee cannot take any of your 401(k) contributions. They are protected from creditors by a federal statute known as ERISA, which stands for the Employee Retirement Income Security Act. This protection is available only as long as the 401(k) account is still untouched. In other words, no money has been removed from the 401(k) account and put into a checking or savings account, or any other unprotected account. Once that happens, the protection is gone, and the trustee is then able to access the funds and disperse them to creditors through bankruptcy.
Other retirement accounts that are protected
There are some annuities, available to particular organizations and non-profit entities, known as 403(b) retirement plans, which are protected from bankruptcy. They are much like 401(k)s, in that they allow employees to make tax exempt contributions until withdrawals are made. Roth IRAs and 457 plans are also generally exempt. The 457 plan is a non-qualified tax advantaged deferred-compensation retirement plan, available to certain employers in the United States. These retirement plans are protected because they contain restrictions on when and how funds can be withdrawn.
If you have questions regarding retirement plans and bankruptcy, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (301) 337-7696.