Your Retirement Plan in Bankruptcy

How will bankrupcty affect your 401(k), IRA, pension, and other retirement plans?

If you file for Chapter 7 bankruptcy or Chapter 13 bankruptcy, you get to keep your pension and retirement plan funds, with a few limitations. If you are considering bankruptcy, you should learn about these limits, and also understand how bankruptcy treats other aspects of retirement planning, such as loans from retirement plans and voluntary contributions to fund retirement plans. (To learn about the basics of Chapter 7 and Chapter 13 bankruptcy, see Nolo's articles A Chapter 7 Bankruptcy Overview and An Overview of Chapter 13 Bankruptcy.)

Retirement Accounts Are Exempt Property

Congress overhauled the bankruptcy laws in 2005. Under the new law, virtually all retirement account and pension plan funds are exempt from creditors, meaning you get to keep them if you file for either Chapter 7 or Chapter 13 bankruptcy. With a few exceptions, the exemption amounts are unlimited, so the entire amount of the retirement account is protected. Plans subject to this exemption include any ERISA-qualified pension plan, such as:

• 401(k)s
• 403(b)s
• IRAs (Roth, SEP, and SIMPLE)
• Keoghs
• profit-sharing plans
• money purchase plans, and
• defined-benefit plans.

The only limits to this broad rule involve traditional and Roth IRAs. For IRAs and Roth IRAs, the exemption from creditors (the amount the bankruptcy court cannot touch) is limited to $1,095,000 per person. If you have more than this in your retirement accounts (the exemption applies to the combination of all of your retirement plans you cannot exempt $1,095,000 for each plan), the excess can be taken by the bankruptcy court to pay back your creditors.This amount is adjusted every three years to account for cost of living increases. 

Although the funds in your retirement accounts are exempt from creditors (subject to the limitations discussed above), retirement benefits that are paid to you as income are not exempt. In a Chapter 7 bankruptcy, the bankruptcy court cannot take any retirement benefits that are necessary for your support, but it could take amounts over and above what you need for your support to repay your creditors. For the purposes of Chapter 13 bankruptcy, this kind of retirement income is included in your repayment plan and will help determine what portion of your unsecured debts you must repay. 

Loans From Retirement Plans

Many retirement plans allow plan participants to borrow money from their retirement account to use for certain types of expenses (such as paying for education or buying a home). This early withdrawal is treated like a loan the money must eventually be paid back to the retirement plan. If you have taken a loan from your retirement plan and are considering bankruptcy, two questions may arise. First, will the loan be discharged (cancelled) at the end of your bankruptcy? Second, does bankruptcy's automatic stay stop you from repaying your retirement plan loan through automatic wage withholdings? Let's look at each question separately.

Are retirement plan loans discharged in bankruptcy? Whether a loan from your retirement plan is discharged at the end of bankruptcy depends on whether you've filed for Chapter 7 or Chapter 13 bankruptcy. In a Chapter 7 bankruptcy, loans from retirement plans are not subject to discharge (cancellation). You'll still be obligated to pay the loan back to the retirement plan at the end of the bankruptcy. This is because Chapter 7 bankruptcy only discharges obligations you owe to others and in the case of a retirement plan loan, you owe the loan to yourself. 

In a Chapter 13 bankruptcy, you pay back all or a portion of your debts over three to five years. At the end of this time period, most of the remaining debt is discharged. Unlike in Chapter 7 bankruptcy, loans from retirement plans can be discharged at the end of a Chapter 13 bankruptcy.

Does the automatic stay apply to wage withholdings to repay retirement plan loans? When you file a bankruptcy petition, most creditors are instantly prohibited from continuing collection efforts against you. This is called the "automatic stay." (To learn more about the automatic stay, see Nolo's article How Bankruptcy Stops Your Creditors: The Automatic Stay.) If you have amounts automatically withheld from your paycheck each month to repay a loan you took from your retirement plan, the automatic stay does not apply to you. The wage withholdings will continue even after you have filed for bankruptcy.

Voluntary Payments to Retirement Plans

In a Chapter 13 bankruptcy, you must use your income to pay some or all of what you owe to your creditors over time from three to five years. The repayment plan must show that all of your disposable income is being used to repay your debts. In determining disposable income, you may deduct only those expenses that are reasonably necessary for the support of you and your dependents. So, for example, you cannot deduct the cost of going to a fancy spa each month.

For the most part, courts don't consider voluntary payments to your retirement plan to be reasonably necessary expenses for purposes of Chapter 13 bankruptcy. This means you'll have to stop the contributions so the bankruptcy court can use the money to repay your debts. But there may be exceptions in certain situations. For example, the court may find that voluntary contributions to a retirement plan are reasonably necessary if the debtor is approaching retirement age and has minimal retirement savings.

If you are considering bankruptcy, consider getting the book The New Bankruptcy: Will It Work for You?, by attorney Stephen Elias (Nolo). This book provides more information on what income and property you are likely to lose in bankruptcy and strategies you'll need to figure out whether bankruptcy is the right solution for your debt problems.