Retirement funds are not always exempt in bankruptcy

After your divorce, your portion of the marital debt, along with the new strain of living on a single income, may have you feeling overwhelmed. Perhaps you have considered using your half of your spouse's 401(k) you received in the divorce to pay off the debt. However, your employer does not offer retirement, and you need that money for your future.

There are federal laws that protect 401(k) plans and other employer-sponsored retirement accounts from creditors. Before you breathe a sigh of relief, you should know there are exceptions, and your retirement award may not have the same protections as your spouse's plan.

The court rules in favor of creditors

Previously, the Supreme Court ruled that the law does not consider funds in an inherited IRA as retirement funds. Therefore, debtors cannot claim they are exempt in a Chapter 7 bankruptcy.

More recently, the U.S. Bankruptcy Appellate Panel for the Eighth Circuit recently ruled that a man filing bankruptcy could not claim a retirement account as exempt because the funds no longer belonged to the original owner. The man filing bankruptcy received half of his former wife's 401(k) funds in the divorce and an IRA and claimed them as exempt.

Protecting divorce assets in a bankruptcy

Even though you are not the original owner, you may still be able to keep at least some of your retirement funds for the future. Assets in an irrevocable trust may have protection during bankruptcy because once you transfer the funds to the trust, they no longer belong to you. Creditors may access disbursed funds you receive from the trust, though, and other exceptions may apply.

Another option that may allow you to keep some or all of your retirement is filing for Chapter 13 rather than Chapter 7 bankruptcy. Instead of liquidating your assets, you reorganize the debt you received in the divorce, creating a payment plan you can afford that stretches over the next three to five years. This may give you the time you need to re-establish your finances after the divorce.

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