It is surprising to many people that they can keep their 401(k) retirement account while still filing for bankruptcy. Under state and federal law, a 401(k) is a protected asset. This can be reassuring to people considering bankruptcy who do not want to lose a lifetime's worth of investment and savings but still have debt on credit cards, medical bills and other unsecured assets. In fact, it is possible to reduce or eliminate credit card debt without losing assets in a 401(k).
Checking, savings and brokerage accounts, on the other hand, are fair game to creditors in bankruptcy. In Chapter 7 bankruptcy, the home, car and many other assets may be liquidated (sold) to pay off creditors. A 401(k) is one of the safer assets protected in bankruptcy.
This can lead to several financial considerations when considering personal bankruptcy. For example, it would be counterproductive to take funds out of a 401(k) in order to pay off certain debts, like a credit card, just before filing. While the assets in a 401(k) are protected, cash extracted may just be another asset for creditors to seize.
It can be tempting to use a 401(k) during bankruptcy to pay off high-interest loans or pay everyday expenses. However, resisting this temptation is in the best interests of the bankruptcy filer. The bankruptcy judge can determine which debt obligations have priority and which need to be reduced, and state laws can protect certain assets during bankruptcy to avoid a bankruptcy filer becoming pennyless.
People considering bankruptcy should consult with an experienced bankruptcy attorney to discuss their situation and to determine the best way to get back on sound financial footing.
Source: Fox Business, "Will my 401(k) be safe if I file for bankruptcy?" Justin Harelik, June 19, 2013