Facing overwhelming debt, many people turn to bankruptcy as a last resort solution. In 2024, a total of 486,613 individuals filed for bankruptcy, marking a 16.2% increase compared to the previous year. This included 464,553 non-business entities and 22,060 business entities seeking bankruptcy protection.
For those nearing retirement or with substantial savings, understanding how bankruptcy may impact their retirement accounts is crucial. The good news is that retirement accounts are typically considered protected assets, and this article will explain how they operate during bankruptcy proceedings.
During bankruptcy, individuals burdened with overwhelming debt can choose to either eliminate or restructure their debt. The two main types of bankruptcy for individuals in the United States are Chapter 7 and Chapter 13.
Chapter 7 Bankruptcy:
Known as “liquidation bankruptcy,” Chapter 7 involves selling non-exempt assets to pay creditors. Some assets are exempt, meaning they cannot be liquidated. In most cases, bankruptcy does not affect retirement accounts like 401(k)s, 403(b)s, and pension plans. While Individual Retirement Accounts (IRAs) and Roth IRAs have exemption limits, they also enjoy protection.
Chapter 13 Bankruptcy:
In Chapter 13, debtors reorganize their debts and formulate a structured repayment plan lasting three to five years. This type of bankruptcy allows individuals to retain their assets, including retirement accounts. When you have higher disposable income, do not qualify for Chapter 7, but wish to retain assets and gradually repay creditors, Chapter 13 is a viable option.
In both types of bankruptcies, retirement accounts are exempt from liquidation.
It’s important to understand that bankruptcy protects some assets from creditor claims while others may not be shielded. Employer-sponsored defined contribution plans, such as retirement accounts, are generally protected under the Employee Retirement Income Security Act (ERISA).
According to the US Department of Labor, ERISA protects these accounts:
– Traditional 401(k)
– Safe Harbor 401(k)
– SIMPLE 401(k)
– Automatic Enrollment 401(k)
– Simplified Employee Pension (SEP)
– SIMPLE IRA
– Keoghs
– Employee Stock Ownership Plans (ESOP)
– Profit Sharing Plans
On the other hand, traditional IRAs and Roth IRAs are not covered by ERISA. However, they are safeguarded under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). As long as IRA funds fall within specific limits adjusted for inflation every three years, these funds are shielded from bankruptcy. As of the writing of this article, the federal bankruptcy exemption for IRAs is $1,512,350.
In summary, the impact varies depending on the circumstances.
Attorney Cara O’Neill at NOLO points out that several factors determine if your pension is safeguarded from creditor claims. These factors include state and federal laws, specific terms of your pension, and the time of purchase.
– State-specific exemption laws may significantly protect some pensions, while others remain unprotected.
– Besides federal bankruptcy law exemptions, certain types of pensions may be tax-exempt, especially those meeting IRS requirements for qualified retirement accounts.
– The timing of purchase.
– The bankruptcy court may scrutinize pensions acquired shortly before bankruptcy.
– Pension type.
– Different pension types, such as fixed, variable, and indexed annuities, may affect their exempt status.
– Funding source.
– Exemption may vary depending on the funding source of the pension.
– State and federal laws.
– The level of protection depends on state and federal bankruptcy laws.
Due to the complexity of bankruptcy law and nuances in pension exemptions, consulting a bankruptcy attorney is essential. Their advice can be tailored to your specific needs and assist you through the legal process.
To make informed financial decisions, understand the factors affecting pension exemptions and seek professional guidance.
While most retirement plans are shielded, there are scenarios where funds may not be 100% protected from creditor claims:
– Withdrawing funds before filing.
– Withdrawing funds from retirement accounts before bankruptcy may jeopardize their exemption status, allowing creditors to access these funds.
– Overpayments or fraudulent payments.
– The bankruptcy trustee may scrutinize excessive or fraudulent retirement payments, subjecting them to review and possible clawback.
– Non-ERISA plans.
– Non-ERISA retirement accounts not covered by ERISA are more susceptible to creditor claims, bankruptcy liens, and litigation. Besides traditional and Roth IRAs, non-ERISA retirement accounts include individual retirement accounts (IRAs) without significant employer involvement. Additionally, some 403(b) plans operated by government entities or churches may be exempt from ERISA.
– Using retirement funds to repay creditors.
– Using retirement funds to repay specific creditors before bankruptcy may be deemed a “preferential transfer,” potentially complicating the bankruptcy process.
– Retirement benefits.
– Retirement benefits may increase debt repayment by factoring into income calculations.
However, there are exceptions to these limitations, including:
– Additional protection from the bankruptcy court.
– Depending on the circumstances, the bankruptcy court may provide extra protection for retirement funds.
– State law exemptions.
– If state law offers broader protection, federal exemptions may not apply to retirement assets.
Whether you are already retired or nearing retirement, understanding how bankruptcy affects your retirement income is crucial. Here’s a breakdown of how Chapter 7 and Chapter 13 bankruptcy, as indicated by Experian, handle retirement income:
– To qualify for Chapter 7 bankruptcy, you must meet specific income requirements. Income from retirement plans such as pensions and 401(k) distributions may be considered in your total income calculations. If your income exceeds certain thresholds, you may not be eligible for Chapter 7.
While retirement funds are typically exempt from bankruptcy seizure, ensuring their full protection is vital. Therefore, consult a bankruptcy attorney to understand the exemptions available in your state.
– In Chapter 13, you’ll establish a repayment plan for some debts. Depending on your retirement income, you may be able to repay loans at a higher rate monthly.
– Similar to Chapter 7, retirement funds are usually exempt from debt repayment. To safeguard your retirement savings, seek the advice of a bankruptcy attorney.
In general, Social Security benefits are unaffected by the bankruptcy process. To keep these funds protected, separate them from other income sources. Ideally, avoid mixing Social Security payments with other funds in shared bank accounts.
If bankruptcy is being considered, consult an experienced bankruptcy attorney to discuss your specific circumstances and explore options to safeguard your retirement assets. Bankruptcy lawyers can help you navigate complex bankruptcy law and protect your retirement income.
Furthermore, avoid premature fund withdrawals. While tapping into retirement accounts for debt repayment may seem tempting, doing so could have severe consequences. Apart from taxes and penalties, withdrawing funds may lead to these funds losing bankruptcy protection.
This cannot be emphasized enough. Understanding how bankruptcy impacts retirement income and seeking legal counsel is the best way to safeguard your financial future.
While bankruptcy poses many challenges, individuals with retirement savings can find relief and security under federal and state bankruptcy laws. In most cases, retirement accounts are shielded from creditor intrusion, alleviating some of the pressures associated with filing for bankruptcy.
Ultimately, understanding how retirement accounts are handled, following best practices, and seeking professional advice can help you rebuild your financial future.