The law is very generous for allowing people who file for bankruptcy (aka “debtors) to keep and protect their retirement accounts. Absent unusual circumstances, retirement accounts, such as IRAs, 401k accounts, and pension plans are generally fully exempt in bankruptcy, meaning that they cannot be taken to pay creditors. One of the most common types of retirement accounts that people have is a 401k account.
A 401k account is generally fully exempt and protected in bankruptcy regardless of how much money is in the account, due to the fact that 401ks are governed by the Federal Employee Retirement Income Security Act of 1974 (“ERISA”). This is because ERISA expressly forbids 401k accounts from being transferred or alienated, such as for the purpose of being taken to pay creditors. It is not uncommon for people to make early withdrawals from their 401k account to pay bills and debts when they become financially stressed. Not only does this drain the funds upon which they will one day rely upon in retirement, but also usually results a significant tax penalty for the early withdrawal of the funds. For these reasons, it is often a huge mistake for a person to drain their 401k account to pay on debts, particularly when those debts can be discharged in a bankruptcy, and the 401k accounts will be exempt from being taken in the bankruptcy to pay debts.
Although 401k accounts are usually untouchable in a bankruptcy, a recent court case has held that a 401k account transferred from one spouse to another in a divorce may not be exempt and protected, in certain limited circumstances (i.e. when it was transferred by a divorce decree without a valid Qualified Domestic Relations Order (QDRO)). The law remains a bit unsettled on the issue of whether 401ks transferred by a divorce decree are exempt as a result of this case and we are awaiting future court decisions to clarify.
It is also common for people to borrow money from their 401k account to pay bills and creditors when they begin to experience difficult financial circumstances. When someone takes out a 401k loan that money must be paid back into the 401k account. Often, the borrower’s employer, who is responsible for maintaining the 401k account, will automatically deduct 401k loan repayments from the borrower’s paychecks. People often mistakenly believe that filing for bankruptcy will discharge their liability for repaying a 401k loan. This is not true. When a person takes out a 401k loan, they are essentially their own creditor, as they owe themselves the money. For this reason, a person who takes out a 401k loan will remain responsible for repaying the loan, even after they receive their bankruptcy discharge. Typically, when a person files for bankruptcy, they are completely protected from the collection efforts of their creditors and cannot legally have their money or property taken to satisfy their debts. This is known as the “automatic stay” and begins on the very first day the debtor files their bankruptcy case. However, one exception to this rule is that 401k loans can continue to be repaid during their bankruptcy, even without the debtor’s permission. Essentially, the debtor’s employer may continue to automatically deduct 401k loan repayments directly from the debtor’s paychecks.
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This is general overview of how 401k accounts and 401k loans are treated in bankruptcy. It is always advisable to consult with an experienced bankruptcy attorney to determine how your particular retirement accounts will be affected by a bankruptcy and determine the best strategy for ensuring the maximum amount of property is protected. See us at LifeBackLaw.com!
