It's one of the worst things that can happen in your life: filing for bankruptcy. Reaching the end of your financial rope is emotionally and fiscally devastating, and the latter can have a lasting effect on your investments.
Types of bankruptcy
In 2016, more than 770,000 people filed for the two most common types of personal bankruptcy:
- Chapter 7: When you have no other means to pay your bills, Chapter 7 bankruptcy liquidates and sells your nonexempt assets to repay your creditors. While unsecured debts like credit card balances are eliminated, secured debts like mortgages and student loans cannot be discharged under Chapter 7.
- Chapter 13: Also known as the "wage earner's bankruptcy," Chapter 13 restructures your debts by putting you on an extended payment plan, usually three-to-five years, that works with your current income. Chapter 13 bankruptcy is preferable to Chapter 7 because it helps you avoid asset liquidation in most cases.
It's easy to think only about the immediate risks and credit damage caused by bankruptcy, but equally important is the impact on your long-term investments. As you move forward, it's imperative to understand which accounts are fair game in the liquidation or restructuring process.
Your 401(k) retirement plan is generally off limits to creditors in bankruptcy proceedings thanks to the federal employee retirement income security act (ERISA), which protects retirement assets during financial hardship. Like your 401(k) plan, investments qualify for ERISA protection if they are employer sponsored or they fall under section 401(a) of the Internal Revenue Code (IRC).
There's one big caveat within 401(k) bankruptcy exemption: the IRS. While your credit card company can't tap into your 401(k) for an overdue balance, the IRS can levy funds to pay your back taxes, though they usually view this step as a last resort.
When it comes to access, the rule of thumb is this: if you can't get to your funds, neither can the IRS. For instance, you can't simply withdraw $10,000 from your account to cover a debt; you'd need to qualify for a hardship withdrawal or apply for a 401(k) loan. So, as long as you aren't receiving disbursals from your 401(k), your money is safe.
But the IRS can levy future disbursals regardless of whether you are receiving income from your 401(k) at the time. For example, suppose you file for bankruptcy at age 40. Federal restrictions limit your ability to take 401(k) withdrawals until you reach age 59 1/2, which means that the IRS can't touch your funds until then, even if they issue a levy against you. That said, they can attach interest and penalties to the principal levy amount, which will compound your debt for the next 20 years.
An alternative to this scenario is cashing out a portion of your 401(k) now in order to satisfy the levy. While early 401(k) withdrawals are subject to income taxes and a 10% penalty, the IRS will waive the latter since you are settling a debt in good faith. Consult your attorney to learn if your 401(k) plan is in danger of a levy, and how to avoid losing valuable income down the road.
Traditional and Roth IRAs
Traditional and Roth IRAs have safeguards in bankruptcy, but protection isn't unlimited. The exemption for IRAs is capped at just under $1.3 million (adjusted every three years for inflation) across all IRA assets rather than each account. The remaining funds can be included in your bankruptcy estate to pay off debts.
However, keep in mind that even exempted funds aren't safe if you are taking IRA withdrawals as income -- the reason being that they are no longer protected under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) and Internal Revenue Code. These regulations exempt assets held in any tax-deferred retirement plan, including traditional and Roth IRAs, from a bankruptcy estate. Withdrawals made from these plans automatically lose their federal protections, which makes them vulnerable during bankruptcy proceedings.
Regardless of your situation, your state's individual bankruptcy laws could provide additional protection. If you sense financial trouble, it's a good idea to avoid withdrawing IRA funds or rolling 401(k) assets into an IRA to take advantage of full fund exemption.
Good news for small business owners: Unlike traditional and Roth IRAs, self-employed plans (SEP) and SIMPLE IRAs aren't included in the aggregate IRA limitation, which means that bankruptcy trustees can't touch them no matter how much money you've saved. That said, the same protection limitations of traditional and Roth IRA withdrawals apply to self-employed plans during bankruptcy, so think twice before cashing yours out as non-exempt income.
Despite their decline in recent years, pensions still provide essential income for millions of Americans. While there are several scenarios, pension safety in bankruptcy usually comes down to two things: whether they are exempt under the tax code and/or considered to be qualified funds under ERISA. In addition to these, protected pensions include:
- Retirement plans listed under sections 401, 403, or 408 of the tax code
- Government-sponsored retirement plans
- Deferred compensation plans
- Controlled group retirement plans provided through churches, the government, business partnerships, or proprietorships
- Retirements plans maintained by a tax-exempt organization, such as churches or some non-profit organizations
In some cases, even non-exempt pensions like stock bonus plans, annuities, and profit sharing plans are protected if you can prove that your livelihood depends on them. Your bankruptcy trustee will review how much you reasonably need to support yourself and your dependents' housing, utilities, food, medical, and transportation expenses, and whether your non-exempt investments are necessary to satisfy those needs.
Other pensions are always non-exempt, including retirement plans not recognized or in violation of U.S. tax code, improperly or illegally funded plans, inherited IRAs (unless received from your spouse), and employee stock purchase plans (ESPPs). Even so, you might be able to qualify for a wildcard exemption, which would allow you to keep a portion of your non-exempt assets up to a certain monetary value. Check your state bankruptcy laws to learn your options.
Profit sharing and employee stock purchase plans
Company profit sharing and employee stock purchase plans (ESPP) are perks used to attract and retain workforce talent. Unfortunately, unless your funds are qualified under ERISA, they aren't protected in bankruptcy proceedings. Your bankruptcy trustee can seize profit sharing accounts and ESPPs as income to repay your creditors and the IRS, when applicable. This rule applies to individual stocks as well. Talk to your plan administrator to learn how your funds are categorized.
529 college savings plans
The rules surrounding bankruptcy and 529 college savings plans rely on ownership. While funds intended for you or your spouse aren't exempt, protections do apply to certain beneficiaries: your child, step-child, grandchild, or step-grandchild. Funds that are gifted to your beneficiaries are no longer legally yours, and therefore, would generally not be considered assets in a bankruptcy estate.
That said, while all funds deposited more than two years before filing are completely exempt, funds deposited between one and two years are only exempt up to $5,000, and anything deposited in the 12 months preceding the bankruptcy disposition can be seized as part of your bankruptcy estate. This is especially true if you dump funds into your child's 529 savings plan just before filing. Not only is your cash fair game, but this move could be considered an act of fraudulent conveyance, or an attempt to avoid repaying debt, which will only make things worse.
One of the main differences between Chapter 7 and Chapter 13 bankruptcy is the handling of real estate, including your primary residence and any investment properties you own. Home equity has tangible value, and filing for Chapter 7 bankruptcy is likely to force you into foreclosure to recoup expenses and make your creditors whole. On the other hand, Chapter 13 aims to help you keep your house as long as you stick to the bankruptcy trustee's debt repayment plan. Yes, your home is fair game in bankruptcy, but losing it is not inevitable.
At the end of the day, filing for bankruptcy is a big decision, one you shouldn't make on your own. Talk to your attorney and your financial planner about the best way to manage your financial travails and protect your investments along the way.