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When you’re in a tight spot financially, you may see your retirement account as a resource to avoid filing for bankruptcy. Sure, paying back all your debts, even unsecured ones, with retirement funds, may seem like the right thing to do, but bankruptcy lawyers argue otherwise. It’s possible that this could end up costing you more than if you file for bankruptcy. That’s because withdrawing retirement funds can lead to a hefty tax penalty if you’re below retirement age and can’t pay back the money you borrowed. 

So, this begs the question: are retirement accounts protected during bankruptcy? Here’s what to know, according to debt relief lawyers. 

Why Can’t I Use My Retirement Funds To Pay Back Debts? 

Let’s start by answering the question as to why you can’t use retirement funds to pay back debts. The reason is that withdrawals from tax-deferred retirement accounts are taxed as regular income. If you’re below the age of 59½, you could even end up paying a 10 percent early withdrawal penalty. 

Once you withdraw retirement funds from the account, they aren’t protected in case you file for bankruptcy. In fact, it could also raise your income, preventing you from passing a 7 Chapter means test or causing you to pay more if you file for Chapter 13. So before you withdraw these funds, it’s best to consult a debt lawyer and understand why filing for bankruptcy is a better option. 

Do Retirement Accounts Stay Protected in Bankruptcy? 

When you’re eligible to file for Chapter 7 bankruptcy, it’s important to understand that much of your debt, such as credit card debt and medical bills, will be discharged. In fact, the money in your retirement accounts is classified as exempt, so it’s protected from creditors. As a result, bankruptcy protections allow you to discharge debt while preserving a crucial asset. 

Whether you’re filing for Chapter 7 or Chapter 13, you can keep the funds in your retirement plans (except for a few limitations. If you’re working with a debt attorney to file for bankruptcy, they can walk you through state rules that determine what you can and can’t keep. 

Protected Retirement Accounts

Filing for bankruptcy doesn’t mean you lose everything. With bankruptcy exemptions, you can protect property such as your home, some household belongings, and a car. All plans that meet Employee Retirement Income Security Act (ERISA) guidelines are considered qualified accounts, so they’re exempt from bankruptcy. 

That being said, these funds are only protected from creditors if they stay in the actual account. Once you withdraw them, they’re treated differently, which increases the chances of losing them. There are even state exemptions on protecting retirement accounts – this is where you can ask your bankruptcy lawyer to inform you regarding state exemptions.  

Aside from a few exceptions, there are no account limitations on amounts in retirement accounts. This means all the money in your retirement account stays protected. It includes 401(k)s, 403(b)s, IRAs, and Keoghs. Defined-benefit plans, profit-sharing plans, and money purchase plans are protected, too.   

Exemption Limits For IRAs

While IRAs are protected, there are limitations on how much of the amount is exempt. This amount is $1,512,350 per person, and it applies to the total amount in all your IRAs rather than individual IRA accounts. If your IRAs hold more, the bankruptcy court can use the additional funds to pay back creditors. 

What Accounts Aren’t Protected 

It’s important to remember that your investment accounts, savings accounts, or stock option plans aren’t given the same protections as qualified retirement plans. So, unless you have a separate cash exemption, the money you save in these accounts is generally not protected. Even if you think of the money as retirement savings, this money can be used to pay back creditors.  

How Bankruptcy Affects Retirement Income 

The above-mentioned conditions apply to potential bankruptcy filers who are below the retirement age. But if you’re already retired, income received from your retirement accounts can affect your bankruptcy. So, even though funds in your retirement accounts are protected from the bankruptcy court, the income you receive from these accounts isn’t exempt. 

Chapter 7 Bankruptcy 

To be eligible for Chapter 7 bankruptcy, your income should fall below the median-level income in your state. If not, you should pass the means test to show that you can’t pay back your creditors. The test considers factors like expenses, unsecured debt, assets, and monthly income. So, if you've already retired, monthly retirement benefits may be used to gauge your income level for a means test. 

If you file for Chapter 7 bankruptcy, you won’t lose any income that’s necessary for your support. However, any retirement benefits that fall beyond what you need for support can be used to repay creditors.

Chapter 13 Bankruptcy 

If you’re filing for Chapter 13 bankruptcy, your monthly retirement benefits help determine a suitable repayment plan. You’ll work with a trustee to reorganize your debt so you can repay some of what you owe during the next five years. The court may factor in retirement benefits when calculating your income, which could end up increasing how much you need to pay back. 

What About Social Security Benefits? 

As long as you keep social security payments separate, your social security benefits are exempt during bankruptcy. Be careful not to deposit your Social Security check into a regular checking account that’s funded by your income. Preferably, you should open up a separate bank account to hold your Social Security benefits. 

Keep Your Retirement Funds Safe When Filing For Bankruptcy 

It’s important to understand what happens to your retirement funds during bankruptcy. Quite often, people who have already retired and are withdrawing retirement funds are considered judgment-proof and don’t have to file for bankruptcy. That being said, it’s still worth consulting a bankruptcy lawyer to understand how you can protect your interests.