After working for the entirety of your adult life to build a nest egg for yourself and your family, the last thing you want is for your 401(k) to disappear into the hands of your cash-starved creditors. If you've recently chosen to file for personal bankruptcy, you may be worried about just such a scenario.
There are two main types of personal bankruptcy. When you file for Chapter 7 bankruptcy, a court-appointed trustee assumes control of the bulk of your non-exempt assets and divides them up among your creditors. Depending upon the jurisdiction in which you live, you may be able to shield significant amounts of real, durable or capital property from your creditors by claiming the maximum allowable "property exemption" in your home state.
When you file for Chapter 13 bankruptcy, the judge overseeing your case will help you work out a debt-repayment plan with your creditors. While you won't be liable for the full amount of your outstanding debts, you may still have to fork over a significant sum.
In either case, your 401(k) plan is considered a protected asset under state and federal law. Whereas your creditors can seize the funds and cash equivalents in your checking, savings and even traditional brokerage accounts, they can't legally touch your intact 401(k).
In fact, 401(k) plans are among the safest investment vehicles to hold through bankruptcy. Even after your creditors have sifted through the bulk of your assets and taken your car, home and cash reserves, your 401(k) will remain in your hands.
For this reason, it's important to resist the temptation to take a loan or early withdrawal from your 401(k) in order to pay off your other debts. While the plan itself is protected, any cash or cash equivalents that originate from it may not be. Your court-appointed trustee will treat your 401(k) loan as just another debt obligation, seizing it for inclusion in your Chapter 7 asset pool or mandating that it become part of your Chapter 13 debt-repayment plan.
If you're close to declaring bankruptcy or have already done so, you may take out a 401(k) loan to pay down high-interest debts or to build up cash reserves to cover the costs of everyday expenses during the bankruptcy process. Both uses are misguided. In the first case, you'd be better off waiting for your bankruptcy trustee or judge to determine how to dispose of your debts. In the second case, you'd likely want to use your state's property exemption to shield some cash or liquid property from your creditors.