If your plan permits loans, you can borrow from your 401(k) plan at any time, including while your bankruptcy is pending. However, it might not be in your best interests to do so. Cashing out your 401(k) plan could be more difficult because the Internal Revenue Service has more restrictions on when distributions can be taken.
Borrowing From Your 401(k)
As long as your plan permits loans, there's no restrictions on when or for what purpose you can borrow money from your 401(k). The IRS limits the maximum you can borrow to the lower of $50,000 or half your account balance. For example, if your 401(k) balance is $92,000, you can borrow up to $46,000.
The loan must be paid back over five years. There's no exception that permits you to use a longer repayment period if you're in the midst of bankruptcy.
Cashing Out From 401(k)
You can only take money out of your 401(k) plan if you've left your job, turned 59 1/2 years old or are experiencing a financial hardship as determined by your 401(k) plan. Examples the IRS gives as financial hardships include medical expenses, funeral expenses, and payments to avoid foreclosure or eviction from your primary residence. However, your plan may permit hardship distributions in even fewer circumstances – or not permit them at all.
If you're still working for the company, are under 59 1/2 and don't meet the hardship withdrawal requirements as defined by your plan, you can't withdraw at all. If you do take a hardship withdrawal, that money is subject to income taxes.
Plus, if you're under 59 1/2 years old, you also pay an extra 10 percent early withdrawal penalty, unless a specific exception applies. These exceptions include medical expenses exceeding 10 percent of your adjusted gross income, a permanent disability or if the IRS levies your 401(k) plan.
401(k) Qualifies as Exempt Asset
Before tapping your 401(k), either with a loan or distribution, while you're in bankruptcy, remember that most retirement plans, including 401(k)s, qualify as exempt assets in bankruptcy. That means that creditors can't take them as part of a bankruptcy settlement. So, if you're taking out 401(k) money to pay off creditors who would be discharged during the bankruptcy, you're wasting your resources.
For example, say you owe $10,000 to a creditor that can be discharged during bankruptcy. If you take out $4,000 from your 401(k) plan to pay down that creditor to $6,000, and then the debt is discharged in bankruptcy, you're out $4,000 – plus any taxes or penalties on the withdrawal.
Effect of Bankruptcy on 401(k) Loans
A loan from your 401(k) plan isn't discharged during bankruptcy because it's essentially money you owe yourself. When you borrow money, you're taking a loan from the value of your 401(k) account and when you repay it, you're putting it back in. If you fail to repay your 401(k) loan, it counts as a distribution from your 401(k) plan, resulting in income taxes and, if you're under 59 1/2 years old, early withdrawal penalties.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."