As a last resort, many people file for bankruptcy when they are faced with overwhelming debt. In fact, 486,613 people filed for bankruptcy in 2024—up 16.2 percent from the previous year. In addition to 464,553 filings by non-business entities, 22,060 were filings by business entities.
However, those nearing retirement or with significant savings wonder how bankruptcy will affect their retirement accounts. The good news is that retirement accounts are generally protected assets, and this article will explain how they are handled during bankruptcy.
Bankruptcy Basics: An Overview
During bankruptcy, individuals who have overwhelming debt have the option of eliminating it or reorganizing it. The two primary types of bankruptcy for individuals in the United States are Chapter 7 and Chapter 13.
- Chapter 7 Bankruptcy: Known as “liquidation bankruptcy,” Chapter 7 involves selling non-exempt assets to pay creditors. Some assets, however, are exempt, meaning they can’t be liquidated. In most cases, bankruptcy does not affect retirement accounts like 401(k), 403(b), and pension plans. Although individual retirement accounts (IRAs) and Roth IRAs have an exemption cap, they also benefit from protection.
- Chapter 13 Bankruptcy: In Chapter 13, the debtor reorganizes his or her debts and creates a structured repayment plan that lasts three to five years. Individuals retain their assets through this type of bankruptcy, including retirement accounts. When you have a high disposable income and don’t qualify for Chapter 7 but prefer to keep your property while gradually paying off your creditors, Chapter 13 is a good option.
With both types of bankruptcy, retirement accounts are exempt from liquidation, providing individuals with peace of mind.
Protected and Unprotected Assets in Bankruptcy
It is important to understand that bankruptcy protects some assets from creditors while others do not. Under the Employee Retirement Income Security Act (ERISA), defined contribution plans such as retirement accounts sponsored by employers are generally protected from creditors.
According to the U.S. Department of Labor, these accounts are covered by ERISA:
- Traditional 401(k)s
- Safe Harbor 401(k)s
- SIMPLE 401(k)s
- Automatic Enrollment 401(k)s
- Simplified Employee Pension Plans (SEP)
- SIMPLE IRA Plans
- Keoghs
- Employee Stock Ownership Plans (ESOP)
- Profit-Sharing Plans
On the other hand, traditional IRAs and Roth IRAs are not protected by ERISA. However, they are protected under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). As long as IRA funds are protected up to a specific limit adjusted for inflation every three years. These funds are not subject to bankruptcy. At the time of writing, the federal bankruptcy exemption for IRAs is $1,512,350.
Are Annuities Exempt in Bankruptcy? A Complex Question
The short answer? It depends.
As Cara O’Neill, an attorney, notes on NOLO, several factors determine whether your annuity is protected from creditors. These include state and federal laws, the specific terms of your annuity, and the timing of its purchase.
1) Understanding State and Federal Exemptions
Annuity exemption laws vary widely from state to state. Depending on the state, some annuities are protected significantly, while others aren’t at all. In addition to exemptions allowed under federal bankruptcy law, certain types of annuities can also be exempted, particularly those that meet IRS requirements for qualified retirement accounts.
2) Key Factors Affecting Annuity Exemptions
- Timing of purchase. There is a possibility that bankruptcy courts will examine annuities purchased shortly before bankruptcy.
- Type of annuity. Different types of annuities, such as fixed, variable, and indexed, can affect their exemption status.
- Funding source. Depending on the source of funds used to purchase the annuity, its exemption may vary.
- State and federal laws. The extent of protection depends on state and federal bankruptcy laws.
3) Consulting a Bankruptcy Attorney
Because bankruptcy law is complicated and annuity exemptions have specific nuances, consulting with a bankruptcy attorney is necessary. Their advice can be tailored to your particular needs, and they can assist you with the legal process.
To make informed financial decisions, you should understand the factors that influence annuity exemptions and seek professional guidance.
Exceptions to Retirement Account Protection
While most retirement plans are protected, there are some circumstances in which funds may not be 100 percent protected from creditors:
- Withdrawing funds prior to filing. Withdrawing funds from retirement accounts before filing for bankruptcy may result in them losing their exempt status, which allows creditors to access the money.
- Excessive or fraudulent contributions. The bankruptcy trustee may hold you accountable for excessive or fraudulent retirement contributions. These contributions may be scrutinized and reclaimed.
- Non-ERISA plans. Retirement accounts that are not ERISA-qualified in bankruptcy proceedings are more susceptible to creditors, bankruptcy claims, and lawsuits. In addition to traditional and Roth IRAs, non-ERISA retirement accounts include individual retirement accounts (IRAs) without substantial employer involvement. Further, some 403(b) plans operated by government agencies or churches may be exempt from ERISA.
- Paying creditors with retirement funds. When you use retirement funds to pay off a specific creditor before filing bankruptcy, this could be construed as a “preferential transfer,” potentially resulting in bankruptcy complications.
- Retirement benefits. A retirement benefit may increase debt repayment by factoring into income calculations.
However, there are also exceptions to these limitations, including:
- Added protection from bankruptcy courts. Depending on the circumstances, bankruptcy courts may provide additional protections for retirement funds.
- State law exemptions. Federal exemptions do not apply to retirement assets if state law offers broader protections.
How Retirement Income Impacts Bankruptcy
Whether you are already retired or are close to retiring, it’s essential to understand how bankruptcy affects your retirement income. As explained by the good folks at Experian, the following is a breakdown of how Chapter 7 and Chapter 13 bankruptcy treat retirement income:
1) Bankruptcy and Retirement Income Under Chapter 7
You must meet specific income requirements to qualify for Chapter 7 bankruptcy. Income from retirement plans, such as pensions and 401(k) distributions, may be considered when computing your overall income. Depending on your income, you may not be able to file for Chapter 7 if you exceed a specified threshold.
Although retirement funds are generally exempt from bankruptcy seizure, ensuring they are adequately protected is essential. As such, ensure you understand the exemptions available to you in your state by consulting with a bankruptcy attorney.
2) Bankruptcy and Retirement Income Under Chapter 13
In Chapter 13, you will create a repayment plan to pay back a portion of your debt. Depending on your retirement income, you may be able to repay your loan each month at a higher rate.
As with Chapter 7, retirement funds are typically exempt from repayment of debts. For your retirement savings to be protected, consult a bankruptcy lawyer.
3) The Impact of Bankruptcy on Social Security Benefits
Generally, Social Security benefits are not subject to bankruptcy proceedings. For these funds to remain protected, they should be kept separate from other income sources. Ideally, you should avoid mixing Social Security payments with other funds in a shared bank account.
Protecting Your Retirement Funds
If you are considering bankruptcy, consult an experienced bankruptcy attorney to discuss your specific circumstances and explore options to protect your retirement assets. A bankruptcy attorney can help you navigate complicated bankruptcy laws and protect your retirement income.
Furthermore, avoid premature withdrawals. Even though withdrawing funds from retirement accounts for debt repayment may seem tempting, doing so can have serious consequences. In addition to income tax and penalties, withdrawals may result in the funds losing their bankruptcy protection.
This can’t be stressed enough. The best way to protect your financial future is to understand how bankruptcy affects retirement income and consult a legal professional.
Final Thoughts
While bankruptcy can be difficult, those with retirement savings can find relief and security under federal and state bankruptcy laws. In most cases, retirement accounts are shielded from creditors, easing some of the stress associated with bankruptcy filing.
Ultimately, understanding how retirement accounts are handled, following best practices, and seeking professional advice can help you rebuild your financial future.
By Deanna Ritchie
The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. NTD does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. NTD holds no liability for the accuracy or timeliness of the information provided.