My earlier answer was incorrect. iOS 4 does incorporate file system level encryption - impressive!
The answer to your question is here:
It is important to understand that GoodReader itself doesn't encrypt
or decrypt your files. It does two things - restricts the access to
protected files via GoodReader's own user interface, and asks iOS to
encrypt certain files (or all of them, if you're using app startup
password). iOS, in its turn, locks these files within a few seconds
after you lock your device with a passcode, and instantly unlocks them
when you unlock your device with a passcode. It means that when you
unlock your device with a passcode, all your files become decrypted
and fully accessible, even if GoodReader app is not being run at the
moment, and you haven't entered any of GoodReader's passwords yet. So,
if your device is unlocked, GoodReader will prevent the access to
protected files via its own user interface, but nothing prevents from
copying these files via, for example, File Sharing section of iTunes
(USB transfer), without knowing GoodReader's passwords. So please be
sure to ALWAYS lock your device with a passcode, even if you leave it
just for a minute. This will turn the physical hardware-based
protection on. And while Auto-Lock option in main device Settings may
be of great help with this, it never hurts to manually lock your
device every time you leave it.
Put concisely, while the iPad is unlocked all data is unencrypted, so in principle, hackers could access your files during this time.