Should You Cash Out a Retirement Plan to Avoid Bankruptcy?

Posted on December 20, 2016 at 3:39pm by
Student debt defaults are on the rise.

For the vast majority of people, financial catastrophe can strike at any moment. Medical bills, divorce, taking care of loved ones, losing your job – these scenarios can be financially disastrous. It may be tempting to raid your IRA or 401k to pay off debts. This is an unnecessary and dangerous decision. You may be surprised to learn you can keep retirement plans in bankruptcy.

Under the Employee Retirement Income Security Act (ERISA), 401(k)s and 403(b)s may not be included in your bankruptcy. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act expanded bankruptcy protections to IRAs and other retirement plans. For traditional and Roth IRAs, funds up to $1,283,025 (as of 2016; this amount will change again in 2019) are protected by federal law during bankruptcy. Depending on the type of IRA plan you have, there might not be a limit. There are also state exemptions on retirement plans. People filing for bankruptcy may have several different avenues to protect their accounts.

There are also ways filers can lose these protections and risk money in their retirement accounts. It may be tempting to transfer money from your retirement account to pay past due bills, but it might hurt you in the long run. Transferring savings from your retirement account to other assets or bank accounts means the money can lose its protected status.

Why Should You Not Raid Your Retirement Account to Pay Bills?

A hypothetical example can explain why it is important not to raid your retirement account when facing financial difficulties.

Jen is a salesperson for a car dealership. Over the last two months, she has experienced night sweats, fatigue, loss of appetite and swollen lymph nodes. Concerned about her dilemma, she schedules an appointment with her doctor. Jen’s doctor tells her she has Hodgkin’s lymphoma. The chances of survival are better than other types of cancer, but she needs to start chemotherapy as soon as possible. Chemotherapy and other tests will cause Jen to accrue thousands in medical expenses. She also must take time off from work due to the stress her job causes and the side effects of the chemotherapy drugs.

Jen misses several months of work and amasses thousands in medical bills, some of which will be covered by her insurance policy. Her total in lost income is $42,400. During this time, she partially relied on credit cards to make ends meet, and has accrued $14,500 in debt. Jen is tempted to pay off the medical bills and credit card debt by using money from her 401(k).

In a strange twist of luck, Jen notices an ad for a bankruptcy attorney appear on her Facebook feed. She calls the bankruptcy attorney from the ad and receives good news. It is possible to keep the money in her retirement account, while discharging the medical bills and credit card debts. Jen passes the means test and files for Chapter 7 bankruptcy.

Is Filing for Bankruptcy the Right Choice?

Medical and credit card debts are unsecured, meaning they are not tied to assets. The story mentioned above is only one example of how someone facing a difficult financial situation with a retirement fund can benefit from bankruptcy.

If you have a retirement account, but also a house, car or other properties that you want to keep while discharging other debts, that may be possible as well. By filing for Chapter 7 or Chapter 13 bankruptcy, you may discover it is possible to discharge cumbersome debts while keeping your most important assets.