IRAs and 401K Plans Aren’t Always Safe in Bankruptcy
If you are considering filing for bankruptcy and have an IRA or 401k, keep reading to under how exemptions work.
Bankruptcy Exemptions
If you’re filing for bankruptcy, knowing the exemptions in your state is essential. Each state has varying amounts of exemptions when it comes to Chapter 7 or Chapter 13 bankruptcy.
It is those exemptions that protect your assets in bankruptcy. Whether your state uses its own or federal exemptions, the exemptions are categorized for different assets.
For example, homestead exemptions protect the equity in your home, motor vehicle exemptions protect the equity in your car, and other exemptions may exist such as for personal injury awards, personal property, or tax refunds.
By knowing the value of your assets and the exemption amounts in your state, you will know to what extent your assets are protected. However, how does that apply to your Individual Retirement Arrangements (IRA) or 401k plan?
Exemptions for Individual Retirement Accounts and 401K Plans
For the most part, IRAs and 401k plans are protected, just like Social Security. However, there could be situations where those funds lose their protection. If the funds become nonexempt, then the bankruptcy trustee is entitled to those funds. The nonexempt funds are disbursed to your creditors.
How IRA or 401k funds become nonexempt is a common problem for debtors filing bankruptcy. For those funds to stay protected, they should remain in those accounts. The problem is when the funds are transferred to a nonprotected account such as a regular checking or savings account.
Common Scenarios in Bankruptcy with IRAs and 401k Plans
As a general rule, bankruptcy is always the last resort. Rarely is bankruptcy the first option for debtors. Typically, debtors will try to negotiate their debt with creditors directly or try with debt relief agencies.
Debt relief agencies or debt reduction companies negotiate with creditors on behalf of debtors to reduce their debt. This could happen by lowering or freezing the interest rates, or reducing the overall balance. Then, one monthly payment is made to the debt relief agency, which disburses payments to the creditors.
Besides negotiating with creditors through debt relief agencies, debtors may try to refinance their debt with personal loans or withdraw funds from an IRA or 401K to help with their monthly expenses or pay off debt.
When IRA and 401k Plans Are not Protected in Bankruptcy
If funds are transferred from an IRA or 401K plan into a regular bank account such as a checking account, it loses its protection. The problem is when substantial funds from the IRA or 401k are transferred to the checking account, and the bankruptcy petition is filed.
Whether the petition was filed without an attorney or the debtor failed to tell their bankruptcy lawyer of the transfer, those funds may be nonexempt and belong to the bankruptcy trustee/estate.
At the beginning of this blog post, I mentioned exemptions and how those exemptions protect your assets and bankruptcy. However, exemptions apply on the date of filing. If those funds were in your checking account when the bankruptcy petition was filed but will be used to pay your mortgage in a few days, the funds may not be protected.
This is a common issue with bankruptcy lawyers who file petitions at the end of the week. If a client gets paid on a Friday and the petition is filed the same day, even if that paycheck is to pay the mortgage, if over-exempt, those funds belong to the bankruptcy estate.
When filing a bankruptcy petition, I confirm my client’s pay date. If I file for bankruptcy the same day they’re getting paid, I ensure exemptions protect them or delay filing for a few days to ensure the funds are used to pay household expenses.
Unfortunately, if the client does not tell their bankruptcy lawyer that they have transferred the funds from an exempt account such as an IRA account or 401k plan, there’s the risk that those funds are non-exempt.
Therefore, when you meet with a bankruptcy lawyer, you must inform them of your intent to withdraw funds from your retirement account or 401K plan.
Likewise, if funds were already withdrawn, then let your bankruptcy lawyer know the amount withdrawn, when, and how the funds were used.
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