After you file for bankruptcy, you can usually get a reprieve from your outstanding debts via the bankruptcy discharge. Unfortunately, if you don't have enough income after your discharge, you may still find yourself in a deep financial hole. If you tap your retirement accounts for living expenses, you may owe additional money in taxes and fees. If you inherit a retirement account, you may lose that money altogether.
The Bankruptcy Estate
When you file bankruptcy, the court puts a temporary stop to all financial matters in your life. While this stop can be beneficial, in that it prevents your creditors from bothering you about your debt, it also means that you cannot dispose of any property you own until the court determines its rightful disposition. In legal terms, all of your property becomes part of a "bankruptcy estate" that the court administers until the end of your case. Since the court may have to make a distribution from your assets to benefit your creditors, you technically do not have the right to liquidate any of it until your case concludes. In this sense, waiting until after your bankruptcy discharge to cash in your retirement is a prudent move.
Cashing in Retirement After Discharge
If your financial situation was dire enough to force you to file for bankruptcy, you may not have any available funds after your discharge to resume a normal life. While your retirement money is by definition intended to be your savings for retirement, it does little good to have retirement savings if you cannot even make it to retirement. If your retirement account is an IRA, you can usually access your funds relatively quickly by completing an IRA distribution form and submitting it to your custodian. If your funds are in an employer-sponsored plan, such as a 401k, you may not be able to take a distribution unless you can demonstrate severe financial hardship. Filing bankruptcy is usually sufficient evidence to qualify for a distribution.
Taxes and Penalties
Unfortunately, regardless of the reason, cashing in your retirement money can create additional financial hardship. For starters, nearly all retirement distributions are reportable as taxable income, the main exception being distributions from a Roth IRA. Furthermore, if you take cash in your retirement account before age 59 1/2, you are taking what the IRS refers to as an early distribution. In addition to your income tax, you have to pay an additional 10 percent penalty tax for any early distributions. By cashing in your retirement account after your bankruptcy discharge, you may find yourself liable for a significant amount of taxes and penalties.
Inheriting an IRA After Discharge
If you happen to inherit an IRA after your bankruptcy discharge, you may be thankful for your good fortune. Unfortunately, you may have to surrender the entire amount of your inheritance to the bankruptcy court. One of the provisions of the bankruptcy estate is that any inheritance you receive within six months of when you filed bankruptcy belongs to the bankruptcy estate. Unless you can exempt the amount of the inheritance using bankruptcy exemption laws, you will generally lose any inherited money you receive within 180 days of filing.
- IRS: Publication 590; Are Distributions Taxable?
- IRS: Publication 590; Early Distributions
- Bankruptcy In Brief; A Service of the Moran Law Group: Property of the Bankruptcy Estate
- U.S. Courts. "Bankruptcy Basics," Pages 9–10. Accessed Aug. 1, 2020.
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John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.