When Congress created the 401k plan in the late 1970s, it took pains to ensure the plans were designed as long-term savings vehicles, specifically for retirement. It granted these plans the privilege of tax deferral to provide workers an incentive to set money aside for the purpose of their own retirement security and further aimed to discourage using the 401k as a glorified savings account. That is why there is a 10 percent penalty on most 401k withdrawals for those under the age of 59 and a half. However, Congress does provide for penalty-free withdrawals in the event of hardships, such as bankruptcy.
Bankruptcy is the legal, court-supervised process in which court officials direct the liquidation or reorganization of an individual's or business's assets to satisfy creditors. Chapter 7 governs liquidation bankruptcies, while Chapter 13 governs reorganizations. In a reorganization, the debtor works out a plan to pay off at least part of the debt.
401ks and Creditor Protection
Congress has provided a good deal of creditor protection to assets within workplace-sponsored retirement plans. Generally, a creditor cannot seize assets within a qualified retirement plan such as a 401k or 403b plan. Congress has also provided general protection for the first $1 million in an IRA. If you make withdrawals from a 401k with bankruptcy imminent, or during the bankruptcy process, you could be inadvertently turning a protected asset into an unprotected asset --- subject to seizure by alert creditors. Contact an attorney prior to making any major moves.
401k Withdrawal Provisions
Generally, withdrawals from 401k plans made prior to the age of 59 and a half are subject to a 10 percent penalty. Those over age 55 and who have separated from their employer may also access their 401ks penalty free, though both groups must still pay income tax on any withdrawals. However, you can avoid the 10 percent penalty for certain hardship-related withdrawals, including withdrawals to avoid eviction or foreclosure, to pay medical expenses or to pay health insurance premiums for yourself or a loved one.
In addition to the asset protection concerns, you must pay income taxes on any amount withdrawn from a 401k. Your employer will withhold 20 percent of the withdrawal and send it to the IRS to pay income taxes with.