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Saturday, April 3, 2010

PLEASE DON'T TOUCH THE 401(K)

PLEASE DON'T TOUCH THE 401(K)

I know it's hard. I know you're desperate. I know you're stressed. I know you're losing sleep.
But whatever you do, don't touch your retirement account. Don't borrow against it. Don't withdraw from it. Leave it alone.
Why?
Because it almost certainly is an exempt asset. That means creditors can't touch it. And more importantly, if you have to file a bankruptcy case, it means that the trustee can't touch it either.
Let me explain.
Whether a debtor in a chapter 7 bankruptcy case is able to keep an asset depends upon whether the asset is "exempt." Most states provide for specific categories of assets to be exempt. If your state doesn't have its own exemption scheme, debtors there will use the federal exemptions. For example, New Jersey does not have state exemptions. So here in the Garden State we use the federal exemptions, which frankly do not provide a lot of protections to debtors. Again, by way of example, the federal homestead exemption is only about $20,000. So if a debtor has equity in his or her home, he or she can protect about $20,000 worth of that equity in a chapter 7 bankruptcy case.
Generally speaking, it is better to have exempt assets than non-exempt assets. If you are in the unfortunate position of needing to restructure your debts and perhaps file a bankruptcy case, your restructuring professional will try to keep exempt assets "off the table" since they generally are unavailable to creditors and the trustee in bankruptcy. So you almost always get to keep these assets.
One of the best categories of exempt assets is retirement accounts. Your 401(k) account or IRA is almost certainly going to be exempt up to its full value. That value might be substantially greater than any other assets that you are able to shield from your creditors. Did you notice when I mentioned that in states like New Jersey, you can only protect about $20,000 in home equity? There is no hard limit on the amount that can preserved in a retirement account.
So what's so bad about liquidating a retirement account? Aside from the fact that you are spending retirement savings that you probably will need later, there are two very bad legal effects. First, there are serious adverse tax consequences to doing so. If you cash out a retirement account, you will owe the IRS a substantial amount as a result. Second, after we have turned an exempt asset into a non-exempt asset, it is very hard to reverse that process.
If you have cashed out your retirement account and later start working with a restructuring professional, there isn't much that we can do to fix it. You generally end up with a large nondischargeable tax debt and limited ability to replenish the retirement account. We have all sorts of techniques that we can use to help our clients through tough times, but nothing in our bag of tricks provides an easy fix to the problems that a liquidated retirement account causes.
So please, just leave the 401(k) or IRA alone. Or call someone like me first.

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