In a usual bankruptcy, creditors are allowed to collect certain "non-exempt" forms of property, such as cash, mutual funds, bonds, a second home or car, coins, paintings, and other luxurious items. 

Alternatively, exempt items are things people need to survive. These include: a minimum income, welfare and social security benefits, unemployment and worker’s compensation, veteran’s benefits, child and spousal support, life insurance, certain court judgments, and other necessary items such as transportation, furniture, and clothing. Retirement savings accounts are also exempt.

Should Debtors Withdraw from Their Retirement Accounts to Pay Off Their Debts?

Withdrawing from retirement accounts to pay for debt is not recommended.

First, retirement accounts are safe during bankruptcy. The only time creditors can access a debtor’s retirement saving accounts is if the accounts are being withdrawn. If the accounts are being used, they will count as income and creditors can use them to satisfy debts. Withdrawing from retirement accounts destroys the protection those accounts have during bankruptcy.

In addition, withdrawing from retirement funds too early may result in IRS taxes and penalties. Not only will the taxes and penalties drive the debtor deeper into debt, the debtor will also have the IRS breathing down their neck. The IRS has stronger collection powers than the average creditor. Withdrawing from your retirement account to pay off a few creditors may result in more debt to a stronger creditor down the road.

Why are Retirement Saving Accounts Exempt?

The government and public policy support people saving for their retirement. In a modern society, children may no longer financially support their parents in their old age. Also, by saving their own money, retirees will not cripple the already overburdened social security and Medicare systems.

In general, accounts exempt from income taxes are also protected in bankruptcy. These accounts include IRAs, Roth IRAs, 401(k)s, 403(b)s, and Keogh plans for self-employed individuals. 

Employer sponsored retirement accounts are protected by the Employee Retirement Income Securities Act (ERISA). The act completely protects employer sponsored retirement accounts from creditors during bankruptcy. Only former spouses and the IRS can pursue employer retirement accounts during and after bankruptcy. The exception is if your employer is a church, a government, or if you are not a US citizen.

How are IRAs Protected?

In 2005, IRAs received even more protection in bankruptcy from both a Supreme Court decision as well as from Congress.  The Supreme Court affirmed that an IRA is protected in bankruptcy provided that it is "reasonably necessary for the support of the debtor." Also, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 created a statutory exemption up to $1 million for retirement accounts, even without a consideration of the filer’s need for the account. 

The BAPCPA was enacted to reduce the benefits of filing for bankruptcy. However, the act is favorable to bankruptcy in regards to retirement accounts. The explanation may lie in that professionals such as doctors can lock their money away in IRAs and have it rest safer against the prying hands of judgment creditors. 

Do States Offer Protection for Retirement Accounts During Bankruptcy?

States do offer protection for retirement accounts through bankruptcy, but the amount and level of protection will differ from state to state. Since the Federal government offers complete protection of employer sponsored accounts through ERISA, state laws are more focused on individual retirement accounts.

Some states offer complete protection. There are no limitations or ceilings. These states include, but are not limited to: New York, New Jersey, and Connecticut. Other states cap the amount of money which can be protected by individual accounts. Nevada, for instance, caps its retirement protection at $500,000.

Finally, some states protect retirement accounts through bankruptcy only if the accounts are "reasonably necessary" for the debtor to keep. California courts determine when it is "reasonably necessary" for debtors to keep their individual accounts based on three factors: age, earning ability and remaining assets.

Do I Need a Bankruptcy Lawyer?

Filing for bankruptcy is a very complicated process. Protecting your retirement should be one of your top priorities during bankruptcy proceedings. A bankruptcy lawyer can ensure that your retirement nest is safe after all said and done.