Should you cash out your 401(k) or IRA to pay off debt? Usually not. Here is why.

If you are thinking about using your retirement savings to pay your debts, I understand why. The people who ask me about this are usually conscientious people who want to do right by the people they owe. They have a retirement balance, they have credit card debt, and using one to pay the other feels like taking responsibility. It is an understandable instinct, and there is nothing to be ashamed of in it. In most cases, though, it is one of the most costly mistakes I see, and it cannot be undone.

The short answer is this: your retirement accounts are among the most strongly protected assets you own, and your credit cards are among the most dischargeable debts you owe. Trading the first for the second, before you know whether you need to, gives up something you would have kept.

Are retirement accounts protected in bankruptcy?

Yes. Retirement money is protected more strongly than almost anything else you own. The protection works in layers, and together they cover most of the retirement money most people have.

• Employer plans governed by ERISA, including most 401(k) and 403(b) plans and pensions, are excluded from the bankruptcy estate altogether. The Supreme Court held in Patterson v. Shumate (1992) that the anti-alienation clause these plans are required to contain keeps them out of the case under 11 U.S.C. § 541(c)(2). The bankruptcy estate is the pool of property the trustee oversees, and these plans are never in it.
• Retirement funds in tax-exempt accounts are also exempt under 11 U.S.C. § 522(b)(3)(C) and § 522(d)(12). An exemption is a category of property the law lets you keep. The § 522(b)(3)(C) exemption applies even in states like Colorado that require filers to use state exemptions.
• Traditional and Roth IRAs are exempt up to a cap under § 522(n). For cases filed on or after April 1, 2025, the cap is $1,711,975. It adjusts every three years. Money rolled over into an IRA from an employer plan does not count against the cap.
• Colorado's own exemption statute, C.R.S. § 13-54-102(1)(s), separately protects funds held in or payable from pension and retirement plans, IRAs, and Roth IRAs.

In twenty-five years of practice, I have not had a client lose a retirement account in a Chapter 7. For most households, the retirement balance is the one thing that is safe regardless of which chapter they file, and I want you to keep it. More on the full list of what Colorado protects is in Colorado bankruptcy exemptions.

What does a withdrawal actually cost?

Usually a third or more of the amount you take out, before counting the growth you give up. A withdrawal from a 401(k) or a traditional IRA is taxed as ordinary income in the year you take it. If you are under 59 and a half, the IRS generally adds a 10 percent additional tax under 26 U.S.C. § 72(t), unless an exception applies. One exception worth knowing: if you leave your job in or after the year you turn 55, distributions from that employer's plan are not subject to the 10 percent tax. That exception does not apply to IRAs.

Put those numbers next to what the $24,640 bought. If the debt it paid was credit card debt, and you end up filing anyway, that debt would likely have been discharged. The withdrawal cost you $15,360 in tax, more than $100,000 in assumed future growth, and it paid a creditor who would have received little or nothing.

There is a second problem in the tax bill itself. Income tax for a recent year is generally a priority debt that is not discharged in bankruptcy. So a withdrawal made to pay dischargeable credit cards can create a new debt, owed to the IRS and the Colorado Department of Revenue, that survives the case.

What about a 401(k) loan instead of a withdrawal?

A 401(k) loan avoids the immediate tax, and it carries a risk people underestimate: what happens if you leave the job. You borrow from your own account and repay yourself through payroll deductions. As long as you keep the job and keep paying, there is no tax.

If you leave or lose the job with a balance outstanding, most plans reduce your account by the unpaid loan. The IRS calls this a plan loan offset and treats it as a distribution: taxable, and subject to the 10 percent additional tax if you are under the age threshold. You can avoid that by rolling the offset amount into an IRA or another plan, and when the offset happens because you left your job, you have until your tax return due date, including extensions, for that year. Most people in financial trouble do not have that cash on hand, which is why the offset tends to become taxable.

What happens to a 401(k) loan if I file bankruptcy?

The loan survives, and in practice you keep repaying it. The automatic stay, the court order that halts collection at filing, does not stop your employer from withholding loan repayments, under 11 U.S.C. § 362(b)(19). The loan is also not dischargeable, under § 523(a)(18). That is less alarming than it sounds, because the creditor is your own account.

In Chapter 13, § 1322(f) says the plan may not materially alter the loan's terms, and the amounts required to repay it are not counted as disposable income. The repayments come off the top before your plan payment is calculated. Courts differ on whether the amount freed up once the loan is repaid must then go into the plan, which is worth raising before you file.

Is an inherited IRA protected?

Not under federal bankruptcy law. In Clark v. Rameker (2014), the Supreme Court held unanimously that an inherited IRA is not "retirement funds" for purposes of § 522(b)(3)(C), because the person who inherits it can withdraw the money at any time without penalty and cannot add to it. A spouse who rolls an inherited IRA into their own IRA is generally in a different position than other beneficiaries.

What if I already withdrew money before filing?

Please do not panic. Many people do this before they talk to a lawyer. The timing and the records matter, and none of it is a reason to hide anything. A trustee reviews what you did in the months and years before filing. Here is what that review typically finds.

1. Cash that is still in your bank account on the day you file. Once retirement money is withdrawn, it is generally no longer held in a retirement account, and it can lose the retirement exemption. At least one Colorado decision has treated a savings account balance left over from a lump sum retirement distribution as not exempt under § 13-54-102(1)(s). Cash in the bank is treated like any other cash, subject to the much smaller exemptions available for it.
2. Payments to creditors in the 90 days before filing. If you paid a single creditor more than $600 in total in that window on consumer debt, the trustee may be able to recover it as a preference, meaning a payment that favored one creditor over the others. For payments to family members and other insiders, the window is one year.
3. Your income for the means test. A withdrawal inside the six month lookback period can count as income, depending on the court and the type of distribution, and can push a household over the Colorado median. The means test article explains the lookback.
4. Your paperwork. The bankruptcy forms ask about income from all sources for this year and the two prior years, and about payments and transfers. Retirement distributions show up on tax forms the trustee will see anyway.

None of this means you did something wrong. It means the order of what happens next matters, and that is a conversation to have before you spend what is left.

What order should I do things in?

Talk to a bankruptcy lawyer before you touch retirement. Bankruptcy is not the answer in every case, but a bankruptcy lawyer is the one person positioned to tell you whether the debt you are about to pay is debt you would otherwise keep.

1. Stop and do not withdraw, borrow, or roll anything over yet.
2. Get a clear picture of what you owe, what kind of debt it is, and what you own, including every retirement account statement.
3. Find out whether bankruptcy is realistic for you, which chapter, and what it would cost against what repaying would cost. If you are comparing a settlement program, debt settlement versus bankruptcy lays out the tradeoffs.
4. If you decide not to file, then weigh a withdrawal or loan with a tax professional, knowing the full cost in the example above.

There are situations where using retirement money is reasonable: a small balance of debt that is clearly payable, a withdrawal that qualifies for a penalty exception, or a debt bankruptcy would not touch, like recent taxes. Those are judgment calls, and you deserve to make them with the whole picture in front of you.

I know how heavy this decision can feel, and you do not have to make it alone. If you have a withdrawal form half filled out, I would be glad to talk with you first in a paid Strategy Session. I look at your accounts, your debts, and your income, and I tell you plainly whether the withdrawal makes sense or whether the money should stay where the law already protects it. The bankruptcy overview and the FAQ are good background, and the contact page is where to schedule when you are ready.