Generally speaking, retirement plans such as 401K are fully protected when it comes to a bankruptcy petition. While many assets can be seized under a Chapter 7 petition, for example, the 401K remains untouched. However, for some people, that 401K protection can be a real trap.
When money is tight and lenders reluctant to extend credit, some people take out loans using their 401K fund as collateral. When it comes to a bankruptcy petition, the current view of the money borrowed is that you are, essentially, borrowing from yourself. Therefore, the loan that has 401K as collateral is not added to the list of debts that can be discharged. In simple terms, you will still need to repay that debt.
If your finances are such that you cannot meet that debt, then the creditor may call in the obligation and claim the funds from the 401K fund. This then introduces a second level of complication. Money going into a 401K fund is tax-deferred so any withdrawal – for example, a creditor making a claim – is seen as withdrawing the funds prior to retirement. This invokes the various income tax liabilities that comes with an early withdrawal.
The final issue involving a 401K fund relates to making contributions while working through a Chapter 13 repayment plan. Some courts will allow a petitioner to continue making these payments, especially if there is some financial gain to be made – for example, employer matching contributions. There are other courts that will not allow these payments on the rationale that a petitioner should not be allowed to increase their assets at the expense of creditors.
If you have a 401K pension plan that you are continually adding to, and you’re considering bankruptcy, consult a bankruptcy attorney first to see what effect bankruptcy will have on your pension. If you have borrowed against that 401K, then you will definitely require the expertise of a bankruptcy attorney.