Your 401(k) is safe. So is a 403(b), a pension, a profit sharing plan and almost anything else your employer sponsors, with no dollar ceiling at all, whether you have $6,000 in there or $1.4 million.
IRAs are different. Federal law caps the protection at an inflation adjusted figure currently above $1.5 million, which is not a limit most people bump into. Rollover money from an employer plan generally does not count against that cap.
Why employer plans get such strong treatment
An ERISA qualified plan contains a restriction on transfer that federal law enforces, which means the money is not really yours to hand to anyone, including a bankruptcy trustee. Section 541(c)(2) keeps it out of the estate entirely. It never becomes property the trustee could sell, so no exemption is even needed.
California adds section 704.115 on top, which fully protects private retirement plans and pensions. For self-directed accounts and IRAs, System 1 protects them to the extent necessary to support you and your dependents at retirement, which is a standard rather than a number. System 2 uses a similar reasonably necessary test for some plans and the federal cap for IRAs.
Do not cash out your 401(k) to pay credit cards
I see this every month and it is the most expensive mistake in consumer bankruptcy. You withdraw $40,000 of fully protected money, pay income tax on it, pay a 10 percent early withdrawal penalty, hand it to creditors who would have been discharged anyway, and then file six months later broke and short a retirement account. The debt was going away. The 401(k) was not.
What happens to money once it leaves the account
Protection follows the account, not the dollars. A pension check that lands in your checking account on the first of the month is cash by the second. Under System 1 there is a tracing provision for certain retirement payments, but it is narrow and it is a fight. Under System 2 you are relying on the wildcard.
The practical rule is that we look at your account balances on the filing date, not on the day you first walked in. If a distribution is coming, the timing of the filing matters more than any argument I could make afterward.
401(k) loans
A loan against your own 401(k) is not a debt in any normal sense. You are borrowing from yourself. It cannot be discharged, it does not go on the creditor list as a claim to be wiped out, and the repayment deduction from your paycheck is treated as an expense in the means test in Chapter 7 and generally in Chapter 13 budgeting.
The bigger risk is losing your job with a loan outstanding, at which point the unpaid balance is treated as a distribution and the tax bill arrives. That has nothing to do with bankruptcy and everything to do with why I ask about it.
“A client came to me having already drained $58,000 from a 403(b) to keep up minimum payments on $61,000 of credit card debt. She still had $54,000 of credit card debt when we met, plus a tax bill from the withdrawal. If she had called a year earlier she would have kept every dollar of it.”
Naomi Reyes-AshfordAccounts you might not think of
- A 529 college savings account for your child, protected within limits that depend on when contributions were made
- Social Security benefits, which are protected by federal law and, when directly deposited and kept separate, by California statute up to a set amount
- An inherited IRA, which the Supreme Court has held is not a retirement fund for exemption purposes and is therefore exposed
- An annuity, where the answer depends on the contract terms rather than on the word annuity
Questions we get asked
Will I lose my pension?
No. Defined benefit pensions are about as protected as property gets in American law, and I have never had a trustee touch one.
Should I stop contributing before I file?
In Chapter 7 it rarely matters much. In Chapter 13 it does, because voluntary retirement contributions reduce the disposable income that funds your plan, and trustees in this district pay attention to contributions that started suspiciously close to filing.
Is my inherited IRA really at risk?
Yes, and this is one of the few genuinely dangerous assets in an otherwise simple case. If you inherited a retirement account from anyone other than a spouse, say so at the first meeting.
What about a Roth IRA?
Roth and traditional IRAs share the same aggregate federal cap. The tax treatment differs, the exemption treatment does not.
Before you touch a retirement account to pay down debt, get a statement for every account you have and spend an hour with a bankruptcy attorney. That hour has saved clients tens of thousands of dollars, and it is the cheapest part of this process.