Can I Lose My Retirement in a Bankruptcy?

Getty Images

You might be excited about retiring soon, but the burden of paying off long-term debt could weigh you down: Should you use some of your retirement savings to pay off this debt? If you file a bankruptcy case, will that get rid of your credit cards? Will you have to give up your retirement accounts?

It’s scary to think about putting out resources to pay old credit card debt, but the thought of losing your retirement makes you even more anxious.

These tips can put some of your concerns to rest.

For the most part, you can protect your retirement funds in both a Chapter 7 and a Chapter 13 bankruptcy, but there are exceptions. Before you start selling any property or taking out a reverse mortgage, I strongly suggest that you get professional advice from a qualified consumer bankruptcy attorney. Some actions you might take could be undone by a bankruptcy filing.

Here’s some general information that will get you started:

What Happens to Retirement Accounts in a Bankruptcy?

Retirement accounts come in many different forms. Fortunately, in a bankruptcy case most of them are protected. Here are some of the more common types of accounts that people use for income in retirement:

  • social security
  • traditional employer-sponsored pension
  • 401(k) account
  • IRA
  • annuity
  • traditional savings account

Whether you keep your retirement funds in a bankruptcy depends on whether the property fits into a classification of what we call exempt property.

What Is Exempt Property?

When you file a bankruptcy case, you goal is to discharge (eliminate) as much debt as you can so that you get a fresh start. In exchange for that discharge, you have to give up the property that you don’t need for that fresh start. What you keep is protected from the bankruptcy court and from your creditors.

We call that exempt property.

To protect your property it has to fit into a certain exemption category, and for the most part cannot exceed a certain monetary limit. Each state has its own set of exemptions, and the bankruptcy code also has a set of exemptions. In some states, you can only use the exemption list set up by the state, but in others you can choose whether to use the state or the federal exemptions.

Many years ago, Congress decided that it was better for society as a whole if retirees can depend on their retirements funds and protect that money from creditors. So, Congress added exemptions for most retirement accounts. Those exemptions are available to people who file bankruptcy even if they choose their state’s exemptions for other property. If you can choose the federal exemptions found in the bankruptcy code, you might be able to protect even more retirement money.

Which Pensions and Retirement Accounts Are Protected?

Unfortunately, most, but not all all retirement money is protected if you file a bankruptcy case. Here are some general guidelines.  

Social Security: Social security payments are safe in a bankruptcy case, at least until they’re deposited into your bank account.

In some states, cash in bank accounts is not exempted. Your best practice would be to keep your social security deposits in a separate account so that they will not be commingled with other funds and therefore harder to trace.

Pensions: Private company pensions are protected if they qualify under a law called the Employment Retirement Income Security Act of 1974 (ERISA). To qualify, these plans must meet certain requirements contained in ERISA and the Internal Revenue Code. Your plan administrator can tell if your plan is qualified.

Pensions from other sources like governments, churches, non-profits, certain partnerships, proprietorships, and tax exempt organizations are not ERISA qualified, but they’re still exempt if they meet other requirements of the Internal Revenue Code.

401(k) Accounts: These investment accounts are protected under Section 401(k) of the Internal Revenue Code, hence the name.

Traditional IRAs and Roth IRAs: Currently, you can protect a total of $1,283,025 in traditional or Roth IRAs. This amount is adjusted every three years.  

Annuities: The Internal Revenue Code protects some annuities, depending on how the annuity was funded and the conditions for payments. For example, an annuity set up to pay you your lottery winnings will not be exempt, but one that starts paying you when you turn 65 will be protected.

Will a Reverse Mortgage Help?

Reverse mortgages are an interesting idea. They’re designed to allow you access to your equity without having to leave your home. In exchange for monthly payments, a lump sum payments, or a line of credit, you agree that your house will go back to the lender once you pass away or permanently move from it.

The real asset here is the equity in your home. Again, we have to go back to state and federal exemptions to determine if the equity is protected. Some states allow you to protect 100% of the equity, but most states limit the amount you can exempt, and they vary widely. In Maine, you can protect $47,500 in equity each, but you can double that to $95,000 if you file a bankruptcy case together. If you're over 60 or disabled, together you could exempt $190,000, which would still leave about $60,000 unprotected.

Maine does not give you the option to use the federal exemptions, but they wouldn’t be of much help you anyway, You be allowed $23,675 each or $47,350 if you both file, much less than what you could protect under the Maine exemptions.

Is the Lake Lot Safe?

This piece of property may be even harder to protect. It won’t qualify for a homestead exemption like your house does. It will only be protected if your state exemptions have a category to cover it. In the federal exemptions, there’s a category called “wild card” that allows you to protect anything up to a value of $1,250 (adjusted every three years), plus up to $11,850 of any unused homestead exemption. Since you’re already presumably using all of your federal homestead exemption, that extra amount won’t be available to you.

Can You Protect the Real Estate Equity Another Way?  

Maybe you’re wondering if there’s any other way to protect the equity on your home or the lot. It may be possible, but it’s tricky and could backfire.

The Hard Way: You could possibly take out a mortgage on the property or sell the lost and deposit the proceeds into your 401(k) or IRA, which are protected accounts.

Here’s why this probably won’t work: You have to disclose most of your financial transactions for the previous one to two years when you file your bankruptcy case. The court will scrutinize those transactions, and if it looks like you were trying to convert nonexempt assets to exempt assets solely to keep the money from your creditors, the bankruptcy court could undo the transaction and use the money to pay your creditors anyway. This is called impermissible pre-bankruptcy planning.

The Better Way: But here’s something that will work. Your credit card debt is $50,000. If you were to file a bankruptcy case, the court would no doubt want you to turn over enough property to pay that debt. But there’s a silver lining here. Even though you owe $50,000, that doesn’t mean that you’ll pay out $50,000. Creditors have to file claims before they’re paid, and those claims have to follow certain requirements, or the trustee (who is appointed by the court to administer your case) can object to the claim and possibly have it thrown out. Other creditors will just not bother to file a claim. Any claim that isn’t filed or allowed by the court will be discharged. Therefore, there’s a pretty good chance you would have to pay off less than $50,000 in debt.  

Does this mean you’ll have to give up your house? That’s one way to handle it. The trustee would sell the house, pay you the full amount of your allowed exemption (up to $190,000 if you qualify under Maine's exemption law), pay the costs of the sale, pay the trustee's own commission (he gets paid a percentage of the funds he administers), and pay all the allowed claims. The court will refund to you anything left over.

As an alternative, you could offer to substitute other nonexempt property or cash so that you can preserve your house and most of your equity in it. Where would that substituted property come from? Most likely, you’d borrow against your equity, either with the reverse mortgage you’re contemplating or a traditional mortgage or home equity line of credit.

So, maybe you’re wondering why file bankruptcy at all; you could just borrow the money now, pay off the credit cards, and avoid the bankruptcy altogether. That’s true. And, you may be able to negotiate with a lot of those creditors to settle for less than what you owe. As the old saying goes, it may be “six of one and a half dozen of the other.” Doing it on your own may take more work on your part, but you won’t have a bankruptcy following you around for the next ten years.

Avoiding Bankruptcy By Using Retirement Accounts to Pay Debts

So, what about the opposite scenario? Instead of taking on more debt to turn equity into exempt property, what if you used your 401(k) and your IRA to pay off your other debt? This is almost never a good idea because you’re using protected money to pay debts that could be eliminated just by filing a bankruptcy case. I’ll let you in on a little secret. This almost never fixes the fundamental problem. You may pay off the debt, but what happens in a few years when you’ve charged up those accounts again? You’ll find yourself deep in debt again with no retirement. And, if you withdraw those funds from your 401(k) or your IRA before you turn 59 and a half, you’ll owe a big fat tax bill the following year.  

The Bottom Line

Before you take any action, you really need to sit down with a knowledgeable consumer bankruptcy attorney. There are tax implications for some of these transactions, and some will take careful planning and timing to satisfy the bankruptcy court if you choose that route. Most consumer bankruptcy attorneys will offer you a free initial consultation, but even if you have to pay for it, the advice will be invaluable.