Filing for bankruptcy means that a debtor must pay back as many creditors as possible before debt is dismissed. Under Chapter 7 bankruptcy, the debtor must sacrifice her assets in order to do so. There are some exemptions to this requirement including any ERISA-qualified (federally regulated) retirement plan. This means the total amount in a 401k is protected under the law, and cannot be sold off to pay creditors. Similarly, filing for Chapter 13, and repaying debt over three or five years, requires that all unsecured creditors are paid up to the value of one’s nonexempt assets. Again, the value of a 401k cannot be included in the valuation of these assets. In both cases, the value of the 401k is unlimited.
Protecting Your 401K
Taking out a loan against your 401K may give lenders a claim against this asset. Under Chapter 13, a repayment plan for all debts and unsecured debts is approved by a court. If you have taken a loan against your 401k, the court may disallow repayments to that loan, as it is essentially a loan to oneself. Because contributions to a 401K are tax-deferred, the only way to access the money prior to retirement age without suffering penalties and tax payments is by taking out a loan. If payments are ceased, you may suffer tax penalties as if it had been an early withdrawal.
Further, taking out a loan against a 401K to pay other debt means that the money is lost to debts that could have been dismissed under Chapter 7 bankruptcy. Because a 401k is an exempted asset than cannot be liquidated, the money taken out as a loan is lost.
Contributing to a 401K During Chapter 13
Prior to the new bankruptcy law in 2005, courts prohibited contributions to 401K plans during repayment under Chapter 13. However, some counts have allowed this contribution, particularly if the company provides a matching amount. Some courts allow this in order to allow the debtor to improve his financial well-being, thereby reducing his risk of again filing for bankruptcy again in the future. However, some courts maintain that creditors take precedence to the debtor’s financial well-being during Chapter 13 repayment.
If you are considering bankruptcy, contact a qualified attorney in your state. An attorney specializing in personal bankruptcy can assist in choosing the best option for your situation.