In general, cashing out your retirement account prior to filing for bankruptcy is almost never a good idea. Retirement accounts enjoy broad protection from creditors in bankruptcy because they are normally either exempt or excluded from the bankruptcy estate altogether. In addition, there are usually severe penalties and negative tax consequences for cashing out your retirement account early. Read on to learn more about why it is a bad idea to cash out your retirement account before filing for bankruptcy.
Many debtors mistakenly believe that they will have to give up almost all of their property if they file for bankruptcy relief. While a Chapter 7 bankruptcy trustee has the power to liquidate your nonexempt assets to pay back creditors, state and federal laws provide exemptions that protect a certain amount of your property in bankruptcy. Specifically, retirement accounts have some of the broadest protections in bankruptcy (discussed below).
Retirement accounts qualified under the Employee Retirement Income Security Act (ERISA) are not considered to be property of your bankruptcy estate. This means that they can’t be taken by the trustee to pay your creditors. This is because ERISA-qualified retirement accounts have certain 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. But if you are not sure whether your retirement account meets ERISA specifications, talk to your employer to make sure.
If your retirement account is not ERISA-qualified or is otherwise deemed to be property of the estate, it will normally still be protected in bankruptcy by both federal and state exemptions. Most retirement accounts that are exempt from taxation under the Internal Revenue Code are also fully exempt in bankruptcy by federal law (you can use this federal exemption no matter which state you reside in). But traditional and Roth IRAs are only exempt up to an aggregate amount of $1,245, 475. In addition, many states have exemptions that protect a certain amount of retirement funds in bankruptcy.
As discussed, retirement accounts enjoy many protections in bankruptcy. As a result, cashing out your retirement account before bankruptcy is normally not in your best interest. The following include some of the disadvantages of cashing out your retirement account.
If you take funds out of your retirement account to purchase other property or simply place them in a bank account, you lose the special protections afforded to retirement accounts. This means that you must find other exemptions to protect the funds you took out or the assets you purchased. It is much simpler to leave the money in your retirement account to make sure it will be safe in bankruptcy.
In addition to losing your bankruptcy protection, cashing out your retirement early can have hefty penalties and negative tax consequences associated with it. If you have not fulfilled your age requirements, you will typically have to pay early withdrawal fees and taxes on any funds you take out from your retirement.