The Effects of Bankruptcy on Retirement Planning

October 21, 2015

effects of bankruptcy on retirement planningIf you find yourself overwhelmed financially, and you are considering whether bankruptcy is the best option for you, a primary concern may be the loss of your assets during the bankruptcy proceedings.  Another concern may also be the effects of bankruptcy on retirement planning.  Clients ask us, "Will filing for bankruptcy force me to give up my retirement benefits?"  This can be very disconcerting if you have worked for many years in order to achieve these hard-earned retirement benefits.
Should I cash out before filing for bankruptcy?
Usually, cashing out your retirement accounts before filing for bankruptcy is not a good idea.  Retirement accounts typically enjoy significant protection from creditors and may be either exempt or excluded from the bankruptcy estate altogether.  Furthermore, there are severe penalties and negative tax consequences when cashing out your retirement accounts before you meet the statutory age for distribution.
Qualified retirement plans are often exempt
Frequently, bankruptcy debtors are allowed to retain certain retirement benefits, which are designated as “qualified” retirement plans.  A “qualified retirement plan” may be generally defined as "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."
The most common “qualified retirement plans” include profit sharing plans (including 401(k) plans), defined benefit plans, and money purchase pension plans.  In other words, a qualified retirement plan is one in which your contributions are not taxed until you withdraw money from the plan.
ERISA Protections for 401(k) contributions
A 401(k) plan is protected from creditors through the Employee Retirement Income Security Act (ERISA).  This protection is available only if the 401(k) account remains intact, meaning that no money has been withdrawn from the 401(k) account and transferred to an unprotected account, such as a checking or savings account.  Once that happens, protection from bankruptcy is lost, as the bankruptcy trustee will now be able to access the funds and disperse them to creditors.
Other protected retirement accounts
Some annuities or retirement plans are protected because they include restrictions on when and how funds from these plans can be withdrawn.  For example, there are some annuities available to particular organizations and non-profit entities, known as 403(b) retirement plans, which are exempt.  They are similar to 401(k)s, as they allow employees to make tax exempt contributions until withdrawals are made.  These annuities are protected from bankruptcy.  Roth IRAs and 457 plans are also generally exempt.  The 457 plan is a non-qualified tax advantaged deferred-compensation retirement plan, available to governmental and certain non-governmental employers in the United States.
If you have questions regarding bankruptcy consequences and protecting your assets, or any other retirement planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.

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