There are certain things a debtor should not do before filing bankruptcy.

I will occasionally have a bankruptcy client ask me if she should withdraw money from her 401k before filing bankruptcy. I also have received questions about whether it is ok to take out of a 401k after filing bankruptcy. My answer is always “that is a bad idea,” but the reasoning as it pertains to a Chapter 7 or Chapter 13 bankruptcy is slightly different, so I will now tackle each one separately.

There are two reasons why it is a bad idea to withdraw from a 401k before filing bankruptcy. The first one is not specific to bankruptcy, but rather to general retirement and tax planning. The penalties associated with an early 401k withdrawal, plus the reduction in your retirement savings, truly make this an option of last resort.

Therefore, the only time I could endorse this strategy in any way is if the debtor is using the money to pay off creditors and avoid filing bankruptcy. I basically would never endorse a 401k withdrawal if it doesn’t resolve the debt situation.

The second factor in withdrawing from a 401k prior to bankruptcy is the impact on the bankruptcy itself. Money saved in a 401k is “exempt” in bankruptcy and cannot be taken by the bankruptcy trustee. However, when it is converted into cash before filing bankruptcy, it loses its exempt status and becomes a non-exempt asset in the form of cash.

Therefore, depending on the amount of money withdrawn from the 401k, it is possible the debtor can now be holding too much cash to exempt and might want to spend down the cash before filing to avoid liquidation. So if the debtor is going to withdraw from the 401k, she should make sure to not withdraw more money than she can exempt.

In a Chapter 7, withdrawing from a 401k after filing is a non-issue to a liquidation since the asset was exempted when the bankruptcy was filed. It would presumably still be an unwise move, but the Chapter 7 itself would not be implicated.

Withdrawing from a 401k in a Chapter 13 would have to be approved by the court because the debtor must commit all of her disposable monthly income to the Chapter 13 plan. Additionally, a 401k withdrawal in a Chapter 13 cannot be used to make the monthly plan payments (those should come from regular monthly income), so there would have to be some unusual reason for the debtor to even need to do this (perhaps a major home repair).

In theory, this withdrawal request would be granted if the circumstances warrant, but again this should only be done as an option of last resort. A Chapter 13 plan modification would most likely be preferable to a 401k withdrawal.

Peter Bricks is a Metro Atlanta bankruptcy and personal injury attorney with offices in Dunwoody, Woodstock and Cumming.