When it comes to bankruptcy and 401k savings, the news is mostly good: money held inside an ERISA-qualified plan such as a 401(k) is generally protected in both Chapter 7 and Chapter 13 and is not handed to creditors. The risks come from what people do before filing, such as cashing out, borrowing against the account, or moving the money somewhere less protected.
If you are considering a withdrawal to keep up with credit cards or a mortgage, pause first. A short free consultation, booked by calling (415) 754-0115 or through our contact page, can tell you whether that money is already out of creditors' reach.
Why a 401(k) is usually safe in bankruptcy
Two layers of federal law work together here.
- ERISA's anti-alienation rule. Qualified employer plans must prohibit assignment of benefits. The U.S. Supreme Court has held that this restriction keeps ERISA-qualified plan funds out of the bankruptcy estate altogether.
- The Bankruptcy Code's retirement exemption. Even apart from ERISA, the Code allows filers to exempt retirement funds held in tax-exempt accounts. For 401(k)s, 403(b)s and similar employer plans, there is no dollar cap on that protection.
California's exemption systems add their own protection for retirement plans, which matters for accounts that fall outside ERISA. The practical effect for most employees in Pleasanton, San Ramon and across the East Bay is simple: the balance in your 401(k) on the day you file generally stays yours.
IRAs are protected differently
Traditional and Roth IRAs are also protected, but the federal exemption for them is capped at an amount adjusted for inflation every three years. Most people are well under it. Rollover IRAs funded from an employer plan are generally treated like the plan they came from, so keep records showing where the money originated.
Accounts that need a closer look
Not every account with "retirement" in its name gets the same treatment. The U.S. Supreme Court has held that an IRA inherited from someone other than a spouse is not protected by the federal retirement exemption, so its status depends on the exemption system you choose. Non-qualified deferred compensation plans, some executive plans and certain annuities also need individual review. If you hold any of these, bring the plan documents rather than just the latest statement.
Bankruptcy and 401k loans
A 401(k) loan is unusual because you are borrowing your own money. The "lender" is your plan, and the loan is repaid through payroll deductions.
In Chapter 7
Because the loan is secured by your own account balance, it is not a typical creditor claim. If you stop repaying, the plan generally treats the unpaid balance as a distribution, which can bring income taxes and possibly an early-withdrawal penalty. Many filers keep paying it.
In Chapter 13
The Bankruptcy Code specifically allows 401(k) loan repayments to continue during a Chapter 13 plan without counting them as disposable income. Once the loan is paid off, the payroll amount that was going to the loan may need to go into the plan instead, which is something to discuss with your attorney when the plan is drafted.
A common trustee question
Trustees sometimes look at whether new voluntary contributions during a Chapter 13 plan reduce what unsecured creditors receive. Courts do not all agree on how to treat them, so this should be reviewed before filing.
Why cashing out before filing can backfire
People under financial stress often raid retirement savings to pay creditors, only to file bankruptcy months later anyway. That sequence can cost a great deal.
- You pay tax on money that was protected. A withdrawal is usually taxable income and may carry an early-withdrawal penalty. The tax bill itself can become a new debt.
- Cash loses its protection. Once the money sits in a checking account, it is ordinary cash. California's exemptions for cash are limited, so the trustee may be able to reach what is left.
- You paid debts bankruptcy could have discharged. Credit cards and medical bills are generally dischargeable. Using retirement money on them converts protected savings into payments that did not need to be made.
- Paying family can be undone. Repaying a relative within the year before filing can be recovered by the trustee as a preference.
Moving 401(k) money into a non-retirement account, or using it to pay down a mortgage in a way that leaves equity exposed, can also raise questions. Our guide to bankruptcy exemptions in California explains how other assets are protected.
What an attorney reviews about your retirement accounts
In a consultation for Chapter 7 or Chapter 13, the attorney will usually want:
- Recent statements for each 401(k), 403(b), pension and IRA.
- Details of any outstanding plan loans and the payroll deduction.
- Records of withdrawals, rollovers or transfers during the last two years.
- Your current pay stubs showing retirement contributions.
The Somal Law Firm represents individuals and small business owners in Pleasanton and throughout Alameda and Contra Costa Counties in Chapter 7 and Chapter 13 bankruptcy, and Bob Somal can review how your retirement savings fit into the case before anything is filed.
Frequently asked questions
Will the trustee take my 401(k)?
In most cases, no. ERISA-qualified plan balances are generally excluded or exempt. Unusual plans or recent transfers are worth checking with an attorney.
Can I keep contributing to my 401(k) after filing?
In Chapter 7, generally yes, since future earnings are not part of the case. In Chapter 13, contributions may affect the plan and should be discussed in advance.
Does a 401(k) count against me on the means test?
The balance is an asset, not income, so it does not count as income. Withdrawals you take during the look-back period may be treated as income.
What about a pension from a former employer?
Qualified pensions are generally protected in the same way as 401(k) plans.
Your retirement savings deserve a second opinion before you touch them. Call Bob Somal at (415) 754-0115 or request a free consultation online. Bring your latest retirement statements and a list of debts, and he will explain what is protected, what is at risk and what your options look like.
Attorney Advertising. This article is general legal information for Bay Area residents, not legal advice, and does not create an attorney–client relationship. Every situation is different — please consult a licensed attorney about your specific circumstances.