First Person: What Happens to My Retirement Assets If I Declare Bankruptcy?

Personal bankruptcies are still on the rise across the United States and I get lots of questions from readers and clients about how it will affect them in the long run. Of particular concern is determining what happens to any 401(k) plans or IRAs. Losing retirement assets can impact you for the rest of your life. Fortunately, in most situations, retirement assets are exempted from liquidation and will still be there when you retire.

The Basics of Bankruptcy

There are two common types of personal bankruptcy filings in the United States. Chapter 7 bankruptcies are often used by individuals who have no assets with which to pay their creditors and no indication that the situation will change in the future. Most assets are required to be sold or otherwise liquidated and that money is distributed to creditors as a final settlement. The debtor is discharged from bankruptcy immediately.

A Chapter 13 bankruptcy allows debtors to hang on to their house, car and other assets and to set up a payment plan with creditors over time. This type of bankruptcy filing is most often used by people who cannot pay all of their debt immediately but have a continuing source of income with which to pay over time.

Both types of bankruptcies will show up on your credit report for 10 years, which may make it difficult to purchase a home or establish new credit.

What Assets are Exempt?

In both types of bankruptcy filings, certain assets are excluded from liquidation or repayment basis. Registered retirement plans, such as 401(k)s and IRAs are included in the list. This allows people who have gotten in over their heads to still retain a retirement income in the future. That means that those assets stay in place. However, if you withdraw funds from either type of plan, it must be included in the filing.

Should I Withdraw my Retirement Assets to Avoid Bankruptcy?

Before taking the giant step of filing bankruptcy, you will assess all of your assets to see if you can avoid it. Selling a house in this shaky real estate market is often not an option and there may not be enough equity in it to make a difference. The next largest asset may be your retirement plan. Under certain conditions, you can withdraw money out of your retirement plans without the 10% early withdrawal penalty. You will still have to pay tax on withdrawals for 401(k) plans and traditional IRAs. The question is: should you drain your retirement funds to avoid declaring bankruptcy?

The answer will depend on many factors, both financial and emotional. You must weigh the fact that you can declare bankruptcy and save your retirement funds against the credit downgrading and stigma of filing. Before making the decision, consult with both an independent credit counselor and tax accountant to make sure that you understand all of the consequences of each choice.

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