401(k)s can be a major factor in retirement planning, adding thousands, or potentially millions, to your savings. Discover the different types of 401(k) plans, how and when to withdraw your funds, and where a 401(k) fits into your retirement strategy.
Saving for retirement is one of the most important financial goals that we need to achieve in our lifetime. The choice of which retirement savings account can help accomplish that goal. Whether it’s a 401(k) offered by an employer or an individual retirement account (IRA) that you established on your own, the benefits of these accounts can help ensure that you’ll have enough money to live on in your golden years.
When employers want to give their employees a tax-advantaged way to save for retirement, they may offer participation in a defined-contribution plan such as a 401(k). Employees would typically contribute a percentage of their salary to their 401(k), while the employer may offer matching contributions up to a specific limit. Employers might also offer a simplified employee pension (SEP) IRA, or a Savings Incentive Match Plan for Employees (SIMPLE) IRA if the company has 100 or fewer employees.
Individuals can opt to save on their own and open an IRA. However, IRAs don’t provide matching contributions from an employer. Various types of IRAs have specific income and contribution limits, as well as their own tax advantages. Both IRAs and 401(k)s grow tax-free, meaning there’s no tax on the interest and earnings over the years. However, distributions or withdrawals from these accounts are typically taxed at your then-income tax rate in retirement.
That said, there are IRAs that offer tax-free withdrawals in retirement. Most IRAs and 401(k)s do not allow withdrawals before the owner reaches the age of 59½; otherwise, there’s a tax penalty levied by the Internal Revenue Service (IRS).1 Again, depending on the specific retirement account and a person’s financial situation, there can be exceptions to the early withdrawal penalty.
Can Creditors Go After My Retirement Accounts?
If you owe a substantial amount of money or have filed for bankruptcy, you might be worried about creditors going after your retirement funds. your 401(k) or IRA retirement accounts are protected from bankruptcy. Unless there are unusual or extreme circumstances, your retirement funds are not part of your “bankruptcy estate.” You will not be expected or forced to drain your retirement funds to get debt relief. Regardless of your financial situation, here is some essential information about what are known as qualified and non-qualified retirement accounts.
Qualified retirement accounts
Retirement accounts set up under the Employee Retirement Income Security Act (ERISA) of 1974 are generally protected from seizure by creditors. ERISA covers most employer-sponsored retirement plans, including 401(k) plans, pension plans and some 403(b) plans. Even if you have accumulated millions of dollars in your retirement account and owe money or have filed for bankruptcy, creditors cannot access funds in these ERISA-qualified plans.
Under ERISA, there’s generally no cap on protected funds. However, there are some instances when money in an ERISA-qualified account may not be protected from creditors. If you are found guilty of a crime and go to prison, for example, the state could garnish those funds to compensate the prison for some of their costs. Your retirement savings might also not be protected if the creditor is a former spouse or the IRS.
Non-qualified retirement accounts
Individual retirement accounts (IRAs), including Roth IRAs, are not protected by the federal government under ERISA. The only exception is in the case of bankruptcy.
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 gives federal protection to IRAs up to $1 million (though money rolled over from an ERISA-qualified plan into an individual account may not be subject to these limits). However, you can lose those protections and the account’s tax-qualified status if you use your IRA for a prohibited transaction, such as pledging it as security for a loan or borrowing from it.
Outside of bankruptcy, state laws determine whether the money in a non-qualified account is protected from creditors. In Michigan, for example, the first $1 million in an IRA is protected from creditors, but inherited IRAs are not protected.
The rules around qualified and non-qualified accounts can be confusing. Check your state’s laws and consider working with an attorney or financial planner to be sure you’re taking the right steps.
The Downside to Using Retirement Funds in Bankruptcy
It may be tempting to reduce your total debt before you file bankruptcy. However, taking retirement money out early comes with penalties, such as:
- Tax penalties if you are under age 66.2-67 (depending on the year you were born)
- Income tax (this number can vary state to state but is often around a 22% tax rate)
- Early withdrawal fees (usually a 10% penalty)
- Losing company matches from your retirement plan
- Losing interest over time
- The account can lose its bankruptcy protection and be used to pay off debts
Your retirement account is considered a “protected asset” under the U.S. Bankruptcy Code.
Protected Assets vs. Unprotected Assets
Protected assets are safe from bankruptcy due to state exemptions, wildcard exemptions, or the amount of money you are allowed to keep in bankruptcy. Unprotected assets can be sold in a Chapter 7 bankruptcy, or paid for under a debt repayment plan in Chapter 13 bankruptcy.
The types of funds that are protected include:
- Employee Retirement Income Security Act (ERISA) plans (sometimes called ERISA pension plans)
- Roth IRAs, SEP IRAs, and SIMPLE IRAs
- Profit-sharing plans
- Defined benefit plans
Unfortunately, your savings account, investments, and stock option plans are not protected accounts. These are not ERISA-qualified accounts and can be used for debt relief or seized by your bankruptcy trustee.
There is a limit to how much retirement money you can keep in bankruptcy. As of the last publish date of this article, the limit is $1,283,025 total per person, so this considers all your accounts and retirement funds combined. Most people do not have this much in their retirement accounts, so it is not an issue for their bankruptcy filing.
Retirement accounts are protected assets. They cannot be taken by bankruptcy trustees and used for debt relief or to pay back creditors. While you can still choose to use your retirement funds when you file for bankruptcy, you will not be forced to do so.
Using Retirement Accounts to Pay One Creditor
You do have the option to withdraw from your retirement account to pay down debt to just one creditor. This must be done before filing Chapter 7 bankruptcy and can only be used for one creditor.
But before you put your financial future — and your retirement — at risk, talk to a bankruptcy lawyer. You do not need to tap into your retirement because of an aggressive creditor, and in most cases, you shouldn’t.
So when does it make sense? It can be handy to finish off a car loan, or to stop a debt lawsuit. It can also be used to pay back personal loans to a friend or family member before you file for bankruptcy. (After you file, the debts are discharged, and they may not get their money back until you can make the payment in the future.)
Unfortunately, because you are picking and choosing between creditors, this might be considered a preferential transfer. It can be voided by your trustee — who can take the money into your bankruptcy estate and distribute it among all your creditors.
Some trustees can void a transfer within 90 days (sometimes even up to two years) before you file for bankruptcy. It will depend on your state, when you file, what Chapter you file for, and the bankruptcy trustee in your case.
Filing for Bankruptcy After Retirement
If you are already using your retirement accounts and receiving retirement income, then bankruptcy will affect you differently. Depending on which Chapter you file, you should consider your total income between your retirement income and funds when it comes to:
- The Chapter 7 Means Test
- The monthly payments for a Chapter 13 repayment plan
You can still qualify for either of these bankruptcies even if you are retired. Keep in mind your Social Security benefits are not income, and do not play a part in either type of bankruptcy.
Bankruptcy Lawyers Can Simplify These Topics
The federal laws in the Bankruptcy Code are confusing, and the rules also change state-by-state. You can discuss your bank accounts, retirement plans, federal bankruptcy exemptions, and more before ever filing bankruptcy. A free evaluation with an attorney can help set yourself up for a fresh start as you start your debt-relief journey.