I frequently speak to potential bankruptcy clients who are struggling with the decision about whether to file Chapter 7 or Chapter 13, or to try to pay their bills by cashing out or borrowing from a 401(k) or pension plan. Is this a good idea?
Generally I am not in favor of liquidating or borrowing against retirement plans to pay debts such as credit cards or personal loans. Given questions about Social Security’s long term solvency, I think you should be very reluctant to take money out of a tax deferred retirement plan.
Funds you withdraw as a liquidation will be subject to state and federal income tax and, if you are under age 59½, they will also be subject to a 10% penalty (except in certain very limited hardship situations). On top of that, the tax liability you will incur will not be dischargeable in bankruptcy.
I especially discourage a retirement plan liquidation if the funds received will not be enough to fully satisfy your outstanding debt. In other words, if you have $25, 000 in your 401(k) and you owe $60,000, your retirement plan money will not pay off your debt. In these situations, I often find that the ongoing interest that accrues on the remaining balance will quickly increase your total debt burden. Many clients have lamented that funds taken from retirement plans had very little effect or benefit.
Should You Borrow Money from your 401(k), IRA or Pension to Raise Funds to Pay Your Debts?
What about taking out a loan against your 401(k)? I also do not like this idea. If you can’t pay back the loan, it will be deemed income and you’ll have to pay income taxes on it (and remember, income tax obligations cannot be discharged in bankruptcy.) And depending on your age, you may still have to pay the 10% early withdrawal penalty.
Retirement Funds: Fully Protected Assets in Bankruptcy
Perhaps the most compelling reason not to liquidate or borrow against your 401(k) has to do with how these plans are treated in bankruptcy. Under the Georgia exemption rules used in Atlanta area bankruptcy cases, your 401(k), IRA or pension is almost always considered exempt property. This means that it does not count as an asset for bankruptcy purposes and no trustee or creditor can get at it.
The net benefit to you is this – in almost every case if you file a bankruptcy, you can keep your 401(k), IRA, or pension, even while your unsecured debt is liquidated or greatly reduced.
If you have not yet touched your retirement plan, make sure to speak to a bankruptcy lawyer before doing so. If you have already cashed out all or part of your plan or borrowed against it, you can still file for bankruptcy, but there will be added complications.