You can withdraw from a 401(k) before you file for bankruptcy, but talk to a lawyer first to make sure you understand all the legal implications. There’s a big difference between “can” and “should.” Just because something is possible, it doesn’t necessarily follow that it’s a good idea.
Your 401(k) is Exempt
As long as your money is in a 401(k), it’s safe from creditors and from liquidation in Chapter 7 -- the bankruptcy protection under which the trustee sells your non-exempt assets and uses the money to pay off your debts. Most retirement plans are exempt from liquidation, including 401(k)s.
You Can Lose the Exemption
When you take money out of your 401(k), it loses its exempt status. If you place it in a bank account, it’s available to your creditors and to the bankruptcy trustee, even if it’s there only temporarily, which could happen for a couple of reasons. If you lose your job and you’re thinking of reinvesting in another retirement fund, the rollover from the 401(k) to the new account must be direct with no stops in between. If you park the money in your bank account, even overnight, it’s no longer exempt.
You might think to take the withdrawal to catch up with your mortgage or car payment so you can try to keep these assets in bankruptcy, but this can be tricky as well. Bankruptcy law doesn’t allow you to give any creditors special treatment in the months before you file. If you give anyone more than $600 within 90 days of your bankruptcy filing date, the trustee can take the money back so it can be shared fairly by all your creditors.
The Money May Count as Income
The other problem with withdrawing from your 401(k) before you file for bankruptcy is that the law considers the money to be income if you take it within six months of your filing date. This could prevent you from filing for Chapter 7 protection because you must pass a means test to be eligible. The test is complex, but if your income is the same as or less than the median income in your state, you don’t have to take it -- you’re eligible for Chapter 7. If your income is at or just below the median but you must add on the 401k withdrawal you took, this may put you over. You’d have to file for Chapter 13 instead, entering into a court-approved payment plan to satisfy your debts through your income over several years.
If You Withdraw After You File
If you really need to take the withdrawal, speak with your lawyer about waiting until after you file for bankruptcy. In some districts, it’s OK for you to take the money as a hardship withdrawal after you’ve set the wheels of your bankruptcy in motion. Technically, everything you own -- even exempt property -- becomes the property of the court after you file until the time that you receive your discharge. You may need permission from the trustee, and you’ll definitely want an all-clear from your attorney, but if you file first, the funds might not lose their exempt status.
You may still have to pay taxes and penalties to the Internal Revenue Service for the early withdrawal, however, if you're younger than 59 1/2. The money counts as income for tax purposes, plus you must pay an additional 10 percent of the amount you withdrew. The IRS waives the 10 percent penalty for certain hardships such as job loss or disability, but you'll still have to pay income tax on the withdrawal, and income tax debts are not easily discharged in bankruptcy.