401(k) Plan and Bankruptcy
The bad news: you are considering filing for bankruptcy. What will happen to your 401(k)? You may be concerned over losing your nest egg along with your other earnings.
The good news: your 401(k) loans are exempt when it comes to bankruptcy. But there are still some aspects to consider.
First, know that filing for bankruptcy will typically be done under Chapter 7 or Chapter 13:
Chapter 7 bankruptcy
When you choose to file for Chapter 7 bankruptcy, the court will assign a trustee who will control most of your non-exempt property. They will then divide the property among all your creditors. Depending on your state’s jurisdiction, you may lay a claim to the maximum property exemption allowed, in order to exempt certain assets from your creditors. Many file a Chapter 7 bankruptcy to get rid of specific debts and start afresh.
Chapter 13 bankruptcy
If you decide to file for Chapter 13 bankruptcy, the judge will help you create a debt repayment plan to pay back your creditors. Your property will not be seized, but you will still have to pay off a large amount of your debts.
Effects on the 401(k) plan
In either a Chapter 7 or Chapter 13 bankruptcy, your 401(k) plan is still considered to be protected under both federal and state law. Creditors may be able to seize cash in your savings, checking and brokerage accounts. But by law, they cannot touch the 401(k) funds.
401(k) loans
Some who file for bankruptcy will apply for a loan against their 401(k) balance, because these loans are easy to come by. Their interest rate is usually quite low and all interest you pay will eventually come back to you. As the money is legally yours, you won’t have to go through a credit approval process.
However, a 401(k) loan usually needs to be paid back within five years. Note that it is also a debt that will not be forgiven, should you file Chapter 7 bankruptcy. Under Chapter 13, a payment plan can be worked out where you don’t have to pay penalties.
For both types of bankruptcy, if you cannot pay back the 401(k) loan before the deadline, it will be considered a withdrawal. You will have to pay a 10% early withdrawal penalty if under 60) and be taxed accordingly.
Disadvantages of using your 401(k) for debt relief
As tempting as it may be, it is generally not a good idea to use your 401(k) plan for debt relief.
Remember that your 401(k) is one of your safest investments through bankruptcy. Even if most of your assets are taken, your 401(k) will still be yours. If you decide to withdraw from your 401(k), it may be seen as income. And this could prevent you from filing Chapter 7.
The 401(k) loan will be treated by the court just as any other debt obligation. It will be seized to be included in your asset pool under Chapter 7, or it will become a part of the debt repayment plan under Chapter 13. Therefore, it’s better not to touch your 401(k) to pay for debt relief.
If you are close to filing for bankruptcy and need cash reserves to cover your everyday expenses, or you want to pay off high-interest debts, take a look at the National Debt Relief website for other options.
