Probably not. 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.
Other factors include severe penalties and negative tax consequences associated with 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.
Find out whether Chapter 7 or 13 is best for you.
Many debtors mistakenly believe that they'll have to give up almost all of their property if they file for bankruptcy relief. 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.
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.
If your retirement account is not ERISA-qualified, it will normally still be protected in bankruptcy by both federal and state exemptions. Most retirement accounts exempt from taxation under the Internal Revenue Code are also fully exempt in bankruptcy by federal law (you can use the federal exemption no matter which state you reside in).
But traditional and Roth IRAs are only exempt to an aggregate amount of $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.
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—especially when you use the funds to pay down debt you could otherwise discharge (erase) in bankruptcy. Here are additional 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 could lose the special protections afforded to retirement accounts. You would have to find other exemptions to protect the funds you took out or the assets you purchased. It's safer to leave protected funds in the retirement account when filing for bankruptcy.
In addition to losing your bankruptcy protection, cashing out your retirement early can have hefty penalties and negative tax consequences. If you haven't reached the proper age, you'll likely have to pay early withdrawal fees and taxes on any funds you take out from your retirement.
Every financial situation is different, and cashing out a retirement account could make sense in some instances. However, it's rarely helpful before filing for bankruptcy.
Because retirement accounts can be a significant asset, it's best to seek the advice of a knowledgeable accountant or bankruptcy attorney before taking action.
Updated April 20, 2022