Think twice before draining 401K or pension plans prior to bankruptcy

If you - like so many other Americans in recent years - are dealing with unmanageable debt, you have likely considered many different ways to get that debt under control. You might have tried working with creditors directly to set up payment plans or get loan modifications without success. When that failed, you may have considered more drastic actions like selling personal items (jewelry or electronics, for example), taking out a loan from a family member or friend, downsizing your home, returning a second vehicle or even emptying your 401K, pension, Roth/IRA or retirement funds.

If you are considering going to extreme measures to get a handle on your debt, keep in mind that you may end up doing yourself more harm than good.

A warning

Before you deplete retirement income sources, think about this: federal and Michigan state bankruptcy laws actually exempt $1.1 million in retirement funds from consideration by the bankruptcy court.

What does this mean for you? It means that the exempted amount is not counted as part of your bankruptcy estate. In practical terms, you might be able to keep the entirety of your pension fund or 401K (provided it is less than $1.1 million) and still get the debt relief benefits offered by filing for Chapter 7 or Chapter 13 bankruptcy protection.

Understanding the nuances of the law

An important nuance to keep in mind if you are planning to file for bankruptcy and still want to be able to keep pension, retirement, 401K or Roth/IRA funds is that the money must actually remain sequestered in those individual accounts to remain protected. If you cash out any of those accounts and deposit the money in a checking or savings account used for general household or personal expenses, it will likely be given to creditors to help pay down your debt. The same is also true if you simply withdraw the cash from retirement accounts and don't redeposit it into a different account.

Another thing to keep in mind is that cashing in retirement accounts early might not only generate significant penalties, but also could leave you owing taxes on the funds. Tax debt is generally not dischargeable in bankruptcy, so you could actually end up in a worse financial situation than you were before. Of course, there is also the possibility that, depending on your age when you file for bankruptcy, you won't be able to adequately replenish your retirement funds and will face financial struggles for many years to come.

To learn more

Are you considering filing for bankruptcy? Do you have questions about the types of accounts and assets that are exempt from consideration by the bankruptcy court? Would you like more information about the different types of bankruptcy and debt relief options available to you? To learn more about the ways in which bankruptcy can help you, contact an experienced bankruptcy attorney in your area.