In a word: NO!!! Please: NO! You should never sacrifice your financial security in retirement to pay current debt. Most importantly, bankruptcy allows you to erase credit card and (most) tax debt and keep your retirement accounts. So why would anyone cash in retirement accounts they will need in the future to pay off today’s debts, if today’s debts can be discharged in bankruptcy? Because most people don’t know better. And that’s why I’m here – to educate you.
What Assets Can Be Taken Through Bankruptcy?
A little-known aspect of bankruptcy law is that you can take the full value of 401k/403b employer accounts with you through a Chapter 7 bankruptcy . That’s right: the full value of the account is exempt from the trustee, even if that value is in the millions (if you have an IRA rather than a 401k, that account’s exemption is limited to only about $1.5 million). What this means specifically is that the Bankruptcy Trustee (who is like a judge on your bankruptcy) cannot cash in your 401k account to pay off your creditors, the way the Trustee can liquidate most any other assets to pay creditors.
This is because, in a chapter 7 bankruptcy, the debtor is briefly transferring legal ownership of everything they own and owe to the Trustee. Debtors in California are allowed to keep a few things though bankruptcy: (1) clothing and household goods and furnishings; (2) wedding and engagement jewelry if under about $10,000 in value; (3) approximately $7,200 in value in a vehicle; (4) the full value of any 401k or 403b retirement accounts; (5) up to $1.5 million in IRAs. And either ONE of the following two “exemptions” (so-called because these assets are exempt from the Trustee’s use): the “Homestead Exemption” which allows a debtor to take up to about $750,000 in equity in a primary residence, or the “Wildcard Exemption” which allows a debtor to take up to $32,000 in any assets they chose such as a mutual fund, a vintage car, an RV, a golf club collection.
Bankruptcy Law Requires Spending Down Most Assets EXCEPT Home Equity and Retirement Savings
In short, bankruptcy law does not allow debtors to take many assets, or valuable assets, through bankruptcy, except for a house and retirement accounts. Bankruptcy laws were written by Congress (the most recent update was in 2005) in such a way that most debtors need to sell or disburse their valuable assets before qualifying for bankruptcy. This is because any assets in excess of those allowed through a chapter 7 bankruptcy (and enumerated in the paragraph above) will be taken by the Bankruptcy Trustee, sold, and the proceeds distributed on a pro rata basis to the debtor’s creditors. To the extent that creditors cannot be fully paid off, any remaining debts are written off (discharged) by the Trustee at the end of the bankruptcy process. The debtor is then given back the assets they are allowed to keep and they have also been legally cleared of their debts.
Few debtors want to go through bankruptcy if they have assets the Trustee would be able to sell to pay creditors. In fact, one of the main purposes of initial meetings with potential clients in a bankruptcy is to determine not just whether they would qualify for bankruptcy’s income thresholds, but whether they should go through bankruptcy – even if they can – based on what they might lose. (Are you concerned about your situation? Call me!). When debtors have assets that are vulnerable to being sold by the Trustee, it almost always makes sense for the debtor to do this themselves, rather than have the Trustee do it. They have more control, they often get better price for their assets, they aren’t paying lawyers to administer the bankruptcy estate, and they get to decide which creditors are paid and which aren’t.
Timing Matters in Bankruptcy
It is sometimes possible to manage the timing of a bankruptcy filing to avoid having some assets taken during the bankruptcy; that’s why I always recommend people speak to me sooner rather than waiting about whether bankruptcy suits the specifics of their financial circumstances. In the case of using bankruptcy to discharge tax debt, those taxes must be three years or older, meaning timing is critical: file too soon and the taxes aren’t dischargeable in bankruptcy; wait to file and you risk nasty enforcement action by the IRS such as liens and levies.
Moreover, when debtors still have assets, there’s also still hope that their financial circumstances will improve in the near future, and they can perhaps avoid bankruptcy altogether. While bankruptcy is sometimes abused, I have only rarely had clients who weren’t mortified that they needed to file bankruptcy. Most people avoid bankruptcy to deal with their debts – often for a very long time.
Don’t Liquidate Retirement Savings to Pay Debt
Which is why many debtors come to me having liquidated the entirety of their retirement savings in an attempt to pay off their debt and avoid bankruptcy. And why I pull my hair out when this happens. They have just severely jeopardized their financial security in old age. Congress very explicitly and specifically exempted retirement accounts from taking by the Trustee during bankruptcy, because they know how important retirement savings are for most of us.
So here’s the purpose of this blog: DO NOT CASH IN RETIREMENT SAVINGS TO PAY OFF DEBT. EVER. YOU DON’T NEED TO DO SO. YOU CAN FILE FOR BANKRUPTCY AND KEEP RETIREMENT ACCOUNTS.
November 14, 2023