Bankruptcy, Do Not Pass Go, Do Not Collect $200. Few people ever plan on filing bankruptcy, but bad investments, bad luck, or just plain bad decision making can make it a possibility for anyone. Nearly 1.5 million people filed in 2011 alone.
One item that is commonly misunderstood by those in financial hardship is the protections given to IRAs and other qualified investment accounts. Keep in mind, bankruptcy laws can vary from state to state, but generally speaking, retirement plans covered by ERISA, such as a 401k or company pension, are fully protected when it comes to a bankruptcy petition.
Additionally, thanks to the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), there are extended protections for a debtor's IRA or Roth as well. The original law exempted up to $1,000,000 in contributory IRA or Roth value, which has since been indexed for inflation up to $1.17 million. This means up to $1.17 million in an IRA can typically not be touched if you file bankruptcy.
Financial advisors are usually quick to recommend investors rollover their 401k/403b/etc. and consolidate them with an existing IRA. While this is usually a time and paperwork saving best practice, one should think twice if total qualified assets are near the $1 million threshold. If one rolls over a 401k account into a rollover IRA, it retains the unlimited bankruptcy protection afforded by ERISA.
However, if funds are commingled with a contributory IRA, they are more likely to be limited to the $1million protection afforded by BAPCPA. So, if you're a business owner, or in a profession at high risk for lawsuits, make sure you're not unknowingly giving up a valuable form of asset protection.
If you've inherited an IRA, the answers aren't as clear cut yet. Different states and courts have ruled both ways as to whether or not an inherited IRA is covered by BAPCPA. Until further court precedent is set, one would be wise to hire an excellent bankruptcy attorney before trying to protect an inherited IRA in court.
Given these protections, what should one do when encumbered with unserviceable debt loads? The most common thing debtors do is to start taking early IRA distributions or 401k hardship withdrawals and loans. Unfortunately, by doing so the funds will become subject to creditors during bankruptcy. If you are on the path to certain bankruptcy, qualified accounts should not be tapped prior to filing due to their preferential treatment.
The tough question arises when one is near retirement and having to decide which is more important, tapping retirement funds to pay large sums of debt, or taking the hit to one's credit report and filing for bankruptcy. Many times it is far more advantageous to take the hit to one's credit report than to deplete qualified accounts that are supposed to be providing income over the next several decades.
So in short, if you have significant debt problems try to resist the temptation to spend or borrow against retirement savings. If you're on the path to bankruptcy, it could be the difference between having over a $1 million perhaps at the end of the day or nothing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.