Certain accounts can’t be touched during a bankruptcy filing and the 401k is one of them.

Under the bankruptcy code a 401k is not property of the estate and creditors have limited access to it.

The federal government has set up bankruptcy as a way of helping people get back on their feet and recover from financial challenges so it makes sense that retirement funds would be protected. If it was required that people first use up all their retirement funds, these same people would likely require government assistance when they reach retirement age.

Warning If Only One Participant

An exception to retirement plans not included in the estate exists for those that have only one participant, such as single employee corporate plans, and some other plans originating in self-employment. These plans may be property of the estate and may be vulnerable to creditors unless subject to an exemption. Get good professional advice if this describes your retirement plan.

Borrowing Against a 401k

Be careful of borrowing against a 401k plan because outstanding 401k loans can present a problem in bankruptcy. Since they are not considered debts, they are not dischargeable. They are also not considered special circumstances that are deducted when calculating the long form means test. So, while you may have to repay the loan it won’t help your case.

In a Chapter 13, the 401k loan can be repaid as part of the plan.

If you are laid off or switch employers the entire loan balance becomes due and must be paid within 90 days to avoid a tax penalty. Tax penalties on early withdrawals can be steep. There is likely an early withdrawal penalty of 10% plus income tax is withheld at 20%. You can pay this balance with a credit card. If you do it right before filing bankruptcy, you’ll have another problem, as the charge will almost certainly be challenged as abuse.

The important warning is – do not use 401k funds to pay off dischargeable credit card debt.

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Image credit: Leo Reynolds

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