Are 401(k)s Exempt from Bankruptcy?

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Good news for people who've been able to save for retirement, but are experiencing financial distress: 401(k)s exempt in bankruptcy.

Exemptions Are Relevant to Chapter 7, Not Chapter 13

First, it's good to remember that there are two types of bankruptcy commonly available to individuals: Chapter 7 (liquidation) and Chapter 13 (debt reorganization). Since Chapter 13 involves coming up with and adhering to a payment plan, not disposing of assets for the benefit of creditors, the fact that 401(k)s are exempt is neither here nor there--assets, whether exempt or not, are not liquidated in a Chapter 13.

However, in a Chapter 7 bankruptcy, exemptions are vital, since any assets--any property or belongings, including  savings--that are not exempt are potentially subject to being liquidated and the proceeds distributed to creditors. (In Chapter 7, after creditors have received as much as they can from the debtor's assets, the remaining balances of any debts are discharged, or eliminated.)

401(k)s are Exempt, or Protected

If property or an asset is exempt, it will not be liquidated for creditors. The federal bankruptcy code, 11 U.S.C. Section 522, specifically makes exempt "retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code"--which includes 401(k)s.

Only Exempt While in the Account

Note that it doesn't matter where assets came from--only what and where they are when you file for bankruptcy. If someone took a large distribution from, or even cashed-out entirely, their 401(k) and put the proceeds into a regular bank or brokerage account, or used them to purchase property, those proceeds are no longer exempt. Once the money is not in a 401(k), it's fair game for creditors. Therefore, if someone anticipates that they may need to declare bankruptcy, that would NOT be the time to take distributions from their 401(k), at least not if they can help it.

How an Attorney Can Help

In addition to 401(k)s, there are a number of other exemptions which a financially distressed debtor may be able to take advantage of. An attorney can help a debtor make sure he or she protects all the property or assets that can be protected under the law.