If you ever find yourself in financial distress, you may consider whether to file for bankruptcy. For most people, when that happens, it is common to be concerned about losing your property. One particular concern is whether bankruptcy will affect your retirement planning? Put another way, you may be concerned about whether you can keep your retirement benefits, which you worked so hard to obtain. Luckily, certain retirement benefits are protected from bankruptcy, depending on how you handle them.
You should not “cash out” your retirement accounts before filing for bankruptcy
Contrary to what many people think, cashing out your retirement account before filing for bankruptcy is not always the best idea. The reality is, retirement accounts have some of the best protections from creditors during bankruptcy. That is because they will usually be exempt or excluded from the bankruptcy estate altogether. You should also consider the stiff penalties that will be imposed if you cash out your retirement accounts early.
Qualified retirement plans are usually exempt from bankruptcy
Under certain circumstances, bankruptcy debtors are allowed to preserve the benefits from qualified retirement plans.” The United States Bankruptcy Code describes a “qualified retirement plan” as follows:
any money or assets, payable to a participant or beneficiary from, or any interest of any participant or beneficiary in, a retirement plan or profit-sharing plan that is qualified under Section 401(a), 403(a), 403(b), 408, 408A or 409 of the Internal Revenue Code of 1986, as amended, except as provided in this paragraph.
Essentially, this means that profit sharing plans (including 401(k) plans), defined benefit plans, and money purchase pension plans are typically exempt. Normally, with these plans your contributions are not taxed until you withdraw money from the plan. It is for this reason they are considered exempt.
ERISA provides protection for 401(k) contributions
Another important fact about retirement planning and bankruptcy is that a bankruptcy trustee is not allowed to take any of your 401(k) contributions. Those contributions are protected from creditors by a federal statute called ERISA, which stands for the Employee Retirement Income Security Act. However, this protection is only available as long as the 401(k) account has never been touched. In other words, you cannot remove any money from the 401(k) account and place it into a checking, savings, or any other unprotected account. If that happens, the funds are no longer protected and the trustee will be able to access the funds and disperse them to creditors through bankruptcy.
An IRA, which stands for individual retirement account, is basically an investment account that carries with it various tax benefits. An IRA can provide a dependable way for you to set aside money for your retirement. With individual IRAs, you are not required to pay taxes on the earnings you receive from the retirement account. Instead, those earnings can be reinvested in order to allow your account to grow rapidly. Then, once you reach retirement age and begin to make withdrawals, your tax obligation will be based on the type of IRA you have, your current income and the amount of your withdrawals.
The different types of IRAs
There are four types of IRAs, each with their own benefits. Traditional and Roth IRAs are opened by individuals. Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) are employer-sponsored IRAs. No matter which type you choose, your IRA is considered “fully vested.” That means all of the contributions you make and earnings you collect belong to you, including any contributions made by your employers.
IRAs have early withdrawal penalties
Regardless of the type of IRA you own, an early withdrawal penalty will be imposed if you receive distributions before you reach the age of 59½. With a traditional IRA, the penalty is an additional 10% in addition to the income tax you are required to pay on those distributions. The Roth IRA requires that you have owned your IRA for at least five years before you start taking distributions, or you will be charged a penalty. One benefit of a Roth IRA, however, is that you can withdraw your original contributions at any time without penalty, because you have already paid income tax on those funds.
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