What Happens When You Pull Money Out Of Your Retirement Accounts
You typically have to pay a penalty for drawing money out of your retirement accounts. Those accounts often have special tax and investment treatment, so you have to agree not to take anything out for a certain amount of time. If you break that agreement, you’ll have to pay – often a lot. In some cases, the penalty is more than half the amount you withdraw! In other words, you may have to pull out more than $100,000 to pay off a $50,000 debt.
That’s a very expensive way to handle payment of a debt. Besides, you need your retirement accounts. That’s what you’ll live off of when you stop working. So, pulling money out voluntarily to pay isn’t a very attractive option.
Your Retirement Accounts Are Safe From Lawsuits
If you don’t pay a debt, your creditors may choose to sue. If they win, they may be able to garnish your wages, repossess your car, or put a lien on your bank accounts. Can they just empty your retirement accounts to satisfy the debt?
In short, no. Your retirement accounts are protected from collection actions in almost every case. The only major exception is the IRS – the federal government may be able to take money out of your retirement account in satisfaction of a tax debt.
While your auto or mortgage lender may be able to threaten repossession or foreclosure, the only legal action an unsecured creditor can actually take is garnishing your wages or putting a lien on your bank accounts. If you pull money out of your retirement accounts, you’re opening it up for a claim by your creditors.
Your Retirement Accounts Are Safe In Bankruptcy
If you’re struggling with debt, bankruptcy may be the best way to get a fresh financial start. However, it can seem like a scary idea. You may be worried about your car, your home, and your personal possessions. And what about your retirement account? You spend years paying into it – you don’t want to lose it in bankruptcy!
How 401(k)s And Retirement Accounts Are Treated In Bankruptcy
Whether you choose to file for Chapter 7 or Chapter 13 bankruptcy, you will very likely be able to keep your retirement. Bankruptcy law is rooted in public policy – people should have a chance to start over with out losing all of their property in the process. To that end, bankruptcy law includes provisions to exempt certain property from the bankruptcy process. Exempt property can’t be claimed by a creditor or taken by the bankruptcy trustee as payment of a debt. California has two different sets of exemptions; you can work with your bankruptcy attorney to decide which set of exemptions best protects your important property. The two sets of exemptions provide slightly different protection for homes, cars, and other property, but both provide extensive protection for retirement accounts.
System 1 exempts:
- 401(k)s
- 403(b)s
- profit-sharing plans
- SEP IRAs
- SIMPLE IRAs
- defined benefit plans
- IRAs and ROTH IRAs up to $1,245,475
- public and county employee retirement accounts
System 2 exempts:
- 401(k)s
- 403(b)s
- profit-sharing plans
- SEP IRAs
- SIMPLE IRAs
- defined benefit plans
- IRAs and ROTH IRAs up to $1,245,475
- ERISA-qualified pensions, annuities, and benefits (insofar as they are necessary for support)
Note that while most bankruptcy exemptions have a dollar limit, most retirement accounts are completely exempt. Up to $75,000 of your home is exempt under System 1, for example, and amounts above that are not exempt. Retirement accounts, with the exception of IRAs and ROTH IRAs, are exempt no matter how much money is in them.
There are a couple of limitations. For example, retirement plans with just one participant (such as a single-employee corporate plan) may not be excluded or exempt. That means that creditors may be able to claim part or all of the account. You’ll need to consult an experienced bankruptcy attorney to determine if your retirement accounts are excluded or exempt. For a more thorough understanding of the status of your retirement plan, discuss the matter with a bankruptcy attorney.
An Example
Bankruptcy law is complicated, so let’s take a look at what might happen to a person’s retirement accounts in bankruptcy. Imagine Adam is close to retirement and has worked for the county for his entire life. He has a defined-benefit pension plan through the county that will pay him $1,500 per month when he retires. He has also saved up $90,000 in a ROTH IRA that he opened when he was young. Unfortunately, Adam has been ill and has had to take on a large amount of medical debt which he can’t pay. He wants to file for bankruptcy to wipe out that medical debt, but what will happen to his retirement?
Adam has a substantial pension from the county. That means he should choose to use the System 1 exemptions because they protect county pensions completely. System 1 also protects a ROTH IRA up to $1,245,475. Adam only has $90,000, so he’s completely protected by System 1.
Now, let’s consider a different scenario. What if he had $2,000,000 in his ROTH IRA? If he chose the System 1 exemptions, his county pension is still completely protected. However, he’s over the limit for his ROTH IRA. That means he’ll only get to keep $1,245,475 of that money. The remaining $754,525 will be use to pay off his creditors. That may very well be enough money to pay off his debts in full – so he may not need to file a bankruptcy at all.
If you have retirement accounts, you should speak to an experienced bankruptcy attorney or financial adviser to discuss your options for rearranging your finances. If your accounts are exempt, it’s often best to let bankruptcy take care of your debts. If your accounts are not entirely exempt, it may make sense to take some money out to pay your creditors. You should never take money out of a fully exempt account and you should never empty other accounts below the exempted amount. For example, you should leave at least $1,245,475 in your ROTH IRA. If you take more out, you’re paying money you wouldn’t otherwise have to pay. Remember also that many retirement accounts penalize you for taking money out early or in large chunks, so you’ll need to check the terms of your account to determine what makes sense for you.
Your Retirement Account And Your Debt
Your creditors may pressure you to take money out of your retirement account to pay off debt – don’t do it! Those accounts are there to provide for you when you’re no longer working. That’s why bankruptcy law protects them. You are not obligated to take money out of your retirement account to pay off creditors. If you file a bankruptcy, your retirement accounts are still safe and your unsecured debts will be gone.
There may be certain situations in which you need to take money out of a retirement account to pay necessary expenses. That’s ok – that’s part of the purpose of a retirement account. However, it’s almost never worth it to pull money out of a retirement account to pay off a debt. If you’re considering that option, you should always speak to an experienced attorney or financial planner to discuss ways to rearrange your finances and to compare the cost of using that money to the costs of other debt management plans.
We Can Help
Many people are afraid that bankruptcy will mean giving up their homes, their cars, and more. There’s a perception that bankruptcy might leave you with nothing. Of course, bankruptcy laws wouldn’t be much use if they left you without a penny to your name. In fact, they’re specifically designed to leave you with what you need to live your life – and that includes retirement accounts. If you’re struggling with debt, contact us today for a free consultation and case evaluation. Even if you don’t think bankruptcy is right for you, we can explain your options for dealing with debt, both in and out of bankruptcy, and help you make the best choice for you.
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