Is Your 401(k) Protected in Bankruptcy?

Yes, the Employee Retirement Income Security Act (ERISA) protects 401(k)s from creditors after a bankruptcy. One of the provisions of the Act prevents creditors from liquidating your retirement savings. This usually applies regardless of the amount held in the account, meaning even high-net-worth individuals with large 401(k)s won’t have them seized and sold off to pay back creditors.

The ERISA does not explicitly extend to self-funded traditional and Roth IRAs. Instead, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) shields up to $1,512,350 in IRAs as of 2023. This limit changes periodically, and there are additional rules pertaining to rollover IRAs.

Some states, including Arizona, have passed additional legislation to extend the full bankruptcy protection of ERISA to IRAs as well. People filing for bankruptcy who are concerned about shielding their retirement savings from creditors should consult with a bankruptcy attorney to learn more.

Why Are 401(k)s Exempt From Bankruptcy Liquidation?

The ERISA was passed to safeguard employee benefit plans and beneficiaries. It primarily deals with imposing fiduciary responsibilities on plan managers and setting minimum standards to protect the interests of people who would rely on those funds in retirement.

The government has an interest in safeguarding these types of plans because it means people will be less likely to rely solely on the government for income and benefits in retirement. Ensuring those plans are a safe haven for assets, including providing some protections from creditors, helps accomplish this goal. 

The added protection against creditors can potentially lead to abuse, which is why there are contingencies built into ERISA’s bankruptcy protections. Retirement savings accounts cannot be legally used reactively to shield assets from creditors for the purpose of avoiding the repayment of debt.

The Exceptions for Retirement Savings and Bankruptcy Vulnerabilities 

There are two primary scenarios in which a bankruptcy filer’s 401(k) may not be protected under the ERISA. These are:

• Excessive 401(k) contributions prior to a bankruptcy filing that are abnormal compared to the filer’s contribution history. For example, if a person normally only contributed $2,000 per year but contributed the maximum for the year immediately prior to filing for bankruptcy.

• Fraudulent conveyance, which is a contribution intentionally made to defraud creditors. The full value of a 401(k) would not be vulnerable to liquidation, only the amount determined to have been deposited with intent to defraud.

Who Determines Whether Contributions Were Excessive or Fraudulent Conveyance?

Bankruptcy trustees are typically responsible for examining the debtor’s actions leading up to the bankruptcy filing. If the trustee doesn’t notice discrepancies, but creditors find signs of excess contributions or fraudulent conveyance, they can raise objections in bankruptcy court.

The ultimate decision on whether either occurred is up to the bankruptcy court, which is responsible for examining evidence, the debtor’s alleged motives and determining whether retirement funds should be seized or exempted.

What About Funds Rolled Over From an ERISA Account Into a BAPCPA Account?

Technically, under federal law, funds rolled over from an account shielded by ERISA, like a rollover IRA, should continue to receive full ERISA protection rather than the more limited BAPCPA protection. However, it’s important to consult with a bankruptcy or tax attorney to understand the full implications and ensure actions aren’t interpreted to be fraudulent conveyance.

Exemptions, Withdrawals and Tax Implications

Legally shielding assets in bankruptcy can be complicated. Debtors filing for bankruptcy are required to thoroughly claim and document all the exemptions they seek to utilize. Mistakes can potentially leave some assets vulnerable to creditors.

Money that is withdrawn from an exempt retirement savings plan will no longer be protected by state or federal law.

Seeking to avoid bankruptcy by withdrawing retirement savings to cover debt could end up being counterproductive.

There can also be serious tax ramifications for early withdrawals. Before making any decisions regarding early withdrawals, it’s likely in your best interest to seek professional advice from a qualified bankruptcy lawyer.



Client-Centric Retirement Savings Guidance in Phoenix

Retirement savers in Phoenix who are seeking retirement planning guidance or investment management services can speak with the financial advisors at Fullerton Financial Planning by calling (623) 974-0300. People in all types of financial situations deserve a secure retirement, and our advisors are here to help.