In my meetings with potential bankruptcy clients I often get asked a version of this question by people who are looking for any last ditch efforts to avoid filing bankruptcy. They generally believe if they pull out a bunch of money and propose a debt settlement with creditors they can avoid bankruptcy. This may or may not be true. There are other concerns to take into account when considering this course of action. One not addressed here, but will be in another post is tax implications.
First, are retirement contributions protected if you file bankruptcy? For those looking to file in the State of Utah, the short answer is yes. However, there are some qualifications. They relate to the fact that the contributions must be in a properly qualified retirement account, which an attorney can help you determine. Second, any contributions to your retirement account made by either you or on your behalf (such as employer contributions) in the twelve (12) months prior to your bankruptcy filing are not protected. Therefore, in Utah if you file Chapter 7 your trustee is likely to require all contributions to your retirement accounts in the last year to be turned over to help pay your creditors. If you file a Chapter 13 case the impact of this can be mitigated. Only an
experienced attorney who understands Chapter 13 bankruptcy can help you work this issue out. Because an experienced bankruptcy attorney like those at Red Rock Legal Services can help you protect your retirement I usually discourage liquidating a retirement account prior to filing bankruptcy.
If you work through a bankruptcy and keep the amounts in your retirement account how can this benefit you? First, there are worst things than bankruptcy, such as not having a retirement waiting for you when you need it. Let do a simple example.
Let’s pretend you have $40,000 in credit card debt running up at 18% interest and a 401(k) from a prior employer in the amount of about $25,000. The thought occurs to you to pull out the money and pay down a chunk of this credit card debt. You need to consider if you withdraw early you will need to pay ordinary income taxes as well as a 10% penalty, reducing the balance by about 25%. So immediately you go from $25,000 in the account to $18,750. If you put that all towards the $40,000 you will still have $21,250 accruing 18% interest and NOTHING in retirement. For many families considering this extreme measure there is a good chance you have put off other expenses and the temptation to use this influx of cash on other items will be great. You might not even be able to get $18,750 to the credit card balances.
There is another much greater cost to you. When you take the money out of the retirement account early you now lose the advantage of the long-term growth that comes with a 401(k). Let’s assume you make no additional contributions to the 401(k) and your $25,000 grows at an average rate of 6% per year for 35 years. At the end your 401(k) would be worth $ 192,152! Every $1,000 you take out of the 401(k) to pay down debt today will cost you $10,281 in future retirement funds. Considering retirement is more or less protected under bankruptcy law in Utah, this is a costly way to pay
credit card debt you can get rid of by bankruptcy and have probably paid on original principle loaned to you out several times over all ready!
