Should I cash out my retirement account before filing for bankruptcy?

Not if you can avoid it. Bankruptcy attorneys find it distressing to hear that a new client drained a retirement account to pay bills. Why? Most retirement accounts are protected in bankruptcy. A filer can wipe out qualifying debt and keep a retirement account, leaving the filer in a solid financial position after bankruptcy. Read on to learn why it is a bad idea to cash out your retirement account before filing for bankruptcy chapter 7 or 13.

Many Retirement Accounts Are Safe in Bankruptcy

Many debtors mistakenly believe they’ll have to give up almost all their property if they file for bankruptcy relief. It’s not the case. State and federal laws provide bankruptcy exemptions that protect a certain amount of your property in bankruptcy, and retirement accounts receive some of the broadest protections.

ERISA-Qualified Retirement Accounts

Retirement accounts qualified under the Employee Retirement Income Security Act (ERISA) aren’t property of your bankruptcy estate. You don’t need an exemption to prevent the trustee from taking the account in Chapter 7, and you don’t have to pay anything to keep the account in Chapter 13.

ERISA-qualified retirement accounts have transfer restrictions that protect them from creditors and those restrictions are enforceable in bankruptcy. Fortunately, most employer-sponsored retirement plans such as 401(k)s, 403(b)s, defined-benefit, and profit-sharing plans are typically ERISA-qualified. If you aren’t sure whether your retirement account meets ERISA specifications, talk to your employer.

Learn more about a 401k in bankruptcy.

Other Retirement Account Exemptions

Traditional and Roth IRAs are only exempt to $1,512,350 per person under federal law. (This figure is current as of April 1, 2022, and will change again on April 1, 2025 - 11 U.S.C. § 522(n).) In addition, many states have exemptions that protect a certain amount of retirement funds in bankruptcy.

Other retirement accounts could still be protected in bankruptcy by federal and state exemptions. But not all are. You’ll want to be especially mindful of investment accounts, which you might personally consider a retirement account but yet have no protection in bankruptcy.

Disadvantages of Cashing Out a Retirement Account Before Bankruptcy

Because retirement accounts enjoy many protections in bankruptcy, cashing out your retirement account before bankruptcy usually is not in your best interest. You certainly won’t want to use the funds to pay down debt you could otherwise “discharge” or erase in bankruptcy. Most filers can get through bankruptcy with their retirement account intact, which helps them recover financially moving forward.

Loss of Protection in Bankruptcy

When filing for bankruptcy, it's safer to leave protected funds in the retirement account. If you take funds from your retirement account to purchase other property or deposit them in a bank account, you could lose the special protections afforded to retirement accounts.

You would have to find other bankruptcy exemptions to protect the funds you took out or the assets you purchased. Protecting cash and money in investment and bank accounts in bankruptcy is challenging, and you could easily make a costly mistake.

Early Withdrawal Penalties and Negative Tax Consequences

In addition to losing your bankruptcy protection, cashing out your retirement can have hefty penalties and unfavorable tax consequences. If you haven't reached the proper age, you'll likely pay early withdrawal fees and taxes on any funds you withdraw from your retirement account.

Seek the Advice of Counsel

Every financial situation is different, and cashing out a retirement account could sometimes make sense. However, it's rarely helpful before filing for bankruptcy if it can be avoided, and it’s almost always a bad idea to use the funds to pay debts that could be discharged in the bankruptcy case. As with all significant assets, it’s best to seek the advice of a knowledgeable bankruptcy attorney before taking action.