Bankruptcy is a legal proceeding initiated when an individual or business cannot meet their financial obligations. There are different types of bankruptcy, all of which are governed by federal law. Consumer bankruptcy is filed when a person cannot pay back the debts they have incurred for personal needs.
Once the bankruptcy proceeding has concluded, the debtor is no longer liable for the debts they have incurred. The bankruptcy court will enter a discharge order which releases the person from their debt. In releasing an individual from their debt, that person has a clean financial slate, but the bankruptcy will remain on their credit report for up to ten years.
In a typical bankruptcy, creditors are allowed to collect certain “non-exempt” forms of property. Some examples of such non-exempt forms of property include:
- Mutual funds;
- A second home or vehicle; and/or
- Coins, paintings, and other luxurious items.
Alternatively, exempt items are things people need in order to survive. Examples of these include:
- A minimum income;
- Welfare and social security benefits;
- Unemployment and worker’s compensation;
- Veteran’s benefits,
- Child and spousal support;
- Life insurance;
- Specific court judgments; and/or
- 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 in order to pay for debt is not generally recommended. This is most commonly because retirement accounts are safe during bankruptcy proceedings. The only time creditors are allowed to access a debtor’s retirement saving accounts is if the accounts are being withdrawn. If the retirement accounts are being used, they will count as income; as such, creditors can use them to satisfy debts. Withdrawing from retirement accounts nullifies the protection afforded by those accounts during the bankruptcy process.
Additionally, withdrawing from retirement funds too early could result in IRS taxes and penalties. Not only will the taxes and penalties drive the debtor further into debt, but the debtor will also face increased pressure from the IRS pursuing them. It is important to remember that the IRS has stronger collection powers than the average creditor. As such, withdrawing from your retirement account in order to pay off a few creditors could result in more debt to a stronger creditor later on.
Why Are Retirement Saving Accounts Exempt from Bankruptcy?
Retirement savings accounts are exempt from bankruptcy because the government, as well as public policy, support individuals saving money for their retirement. Generally speaking, accounts exempt from income taxes are also protected in bankruptcy proceedings. These protected accounts include:
- Roth IRAs;
- 403(b)s; and
- Keogh plans for retiring self-employed individuals.
Retirement accounts that are sponsored by an employer are protected by the Employee Retirement Income Securities Act (“ERISA”). The Act was intended to create reform for pension and retirement plans held by people who work in the private sector; and, to prevent abuse of those plans by their administrators. It requires that there be clear information available to the plan owners regarding the details of their plans.
As enacted by ERISA, some of the types of information that are required to be provided include:
- General features of the plan, and how it is funded;
- Length of Service, as it is common that an employee must work for their employer for a certain amount of time before they can participate in the plan;
- Minimum contribution requirements;
- Time of vesting, or, the amount of time in which an employee must work before they are granted access to all of the funds;
- Process for appealing; and
- Right to Sue.
ERISA provides minimum standards for things like funding and vesting of plans, and completely protects employer sponsored retirement accounts from creditors during bankruptcy proceedings. Only former spouses and the IRS may pursue employer retirement accounts during and after bankruptcy. The only exception to this is if your employer is a church or a government, or if you are not a US citizen.
How Are IRAs Protected?
In 2005, IRAs received additional protection in bankruptcy from both a Supreme Court decision, as well as from Congress. The Supreme Court affirmed that an IRA (individual retirement account) is protected in bankruptcy, so long as the IRA is “reasonably necessary for the support of the debtor.” Additionally, the Bankruptcy Abuse Prevention and Consumer Protection Act (or, BAPCPA) of 2005 created a statutory exemption of up to $1 million for retirement accounts. This is true even without a consideration of the filer’s need for the account.
The BAPCPA was enacted in order to reduce the benefits of filing for bankruptcy. However, the Act is favorable towards bankruptcy in regards to retirement accounts. The explanation for this could be that professionals, such as doctors, can lock their money away in IRAs.
Do States Offer Protection for Retirement Accounts During Bankruptcy?
Some protection for retirement accounts through bankruptcy is offered at the state level. However, the amount and level of protection will differ from state to state. As the Federal government offers complete protection of employer sponsored accounts through ERISA, state laws are generally more focused on individual retirement accounts.
Some states do offer complete protection for retirement accounts during bankruptcy. This means that in the following states there are no limitations or ceilings for bankruptcy protections concerning retirement accounts. These states include, but are not limited to:
- New York;
- New Jersey; and,
Other states cap the amount of money which may be protected by individual accounts. An example of this would be Nevada, as it caps its retirement protection at $500,000. Additionally, some states protect retirement accounts through bankruptcy, but only if the accounts are “reasonably necessary” for the debtor to keep.
An example of this would be how California courts determine when it is “reasonably necessary” for debtors to keep their individual accounts. This determination is based on three factors:
- Earning ability; and
- Remaining assets.
States such as Texas allow you to choose between federal bankruptcy exemptions and state bankruptcy exemptions. In regards to retirement or pension accounts, most retirement accounts and tax exempt pensions are protected under Texas law. The following retirement and pension benefits are examples of exemptions in Texas:
- Judges, county, and district employee retirement and pension benefits;
- Firefighter and law enforcement retirement and pension benefits;
- Elected officials, municipal employees, or other state employees retirement and pension benefits;
- Teacher retirement and pension benefits; and
- ERISA-qualified benefits for government or the church.
It is important to review your state’s laws concerning bankruptcy and exemptions, as your state’s laws may provide additional exemptions beyond the federal bankruptcy exemptions.
Do I Need a Bankruptcy Lawyer?
ERISA is enforced by:
- The Labor Department’s Employee Benefits Security Administration;
- The Internal Revenue Service; or
- The Pension Benefit Guaranty Corporation.
If you are experiencing any issues with keeping your retirement account exempt from bankruptcy proceedings, you should consult with a skilled and knowledgeable bankruptcy lawyer in your area. An experienced and local bankruptcy attorney can help you contact the aforementioned ERISA enforcers in order to report the violation. Additionally, an attorney can also assist with all legal aspects of filing for bankruptcy. Finally, an experienced bankruptcy lawyer will also be able represent you at chapter 341 meetings, or in court as needed.