Should I Dip into Retirement Savings or File Bankruptcy?

It’s a dreadful thought for many small business owners, but life during COVID-19 reveals the time has come when many ask themselves: Should I borrow from my retirement savings to keep my business afloat, or is it time to consider bankruptcy?

“Almost always, the answer is no,” Lakeland bankruptcy attorney Keith Merritt says. “In Florida, you should consult a lawyer about whether you should spend your hard-earned retirement savings. The threshold and most difficult question is whether your business is going the way of the buggy-whip and the typewriter. If your personal situation is or may become precarious and you are able to eliminate debt through bankruptcy, spending money now on high-interest credit cards is unwise when you can spend it later on food, clothing and shelter for yourself and your family if necessary.”

Bankruptcy Filings are Rising

The total number of commercial chapter 11 bankruptcy filings during the first six months of 2020 increased 26 percent over the same period in 2019, according to the American Bankruptcy Institute.

Chapter 11 bankruptcy is known as “reorganization bankruptcy” for corporations, sole proprietorships and partnerships. It enables those who file to create a plan to restructure contracts, determine which assets to liquidate and to what extent creditors will be repaid.

In addition to Chapter 11, other primary bankruptcy chapters are:

• Chapter 7- Individuals and business owners protect themselves from creditors. It stops collections calls, lawsuits and wage garnishments.
• Chapter 13- Individuals or self-employed workers keep their assets and pay off a portion of their debts over time.

Retirement Savings is not an Emergency Fund

In an ideal world, you leave your retirement savings accounts alone until you reach retirement age, and rules are in place to encourage you to do so. Consider these facts before using this resource:

• Most retirement savings plans carry a 10 percent penalty if you tap into them before you reach age 59 ½. Additionally, you also may have to pay income tax on the funds you withdraw.
• Withdrawing funds early from retirement savings can increase the risk of a shortfall once you enter retirement.
• Remember the purpose of retirement savings, which is to fund your living expenses in retirement; not to support your business.

In general, it’s unwise to borrow from a retirement account without first seeking professional advice.

“Private pensions were intended to unburden Social Security with the notion that people can capably manage their retirement accounts,” Merritt says. “I find that when they think their backs are against the wall they will wrongly use retirement accounts only to put off difficult financial decisions. It is financial blasphemy to spend retirement accounts on credit card and other non-priority, unsecured debt.”

Borrowing from your 401k lessens the power of compounding interest. The March 2020 CARES Act enables you deeply dip into employer retirement plans by increasing the borrowing limit to 100 percent of the vested account balance or $100,000, whichever is less. That further hobbles compounding interest opportunities. The CARES Act has changed other rules related to 401k borrowing, so I recommend reading more about those details on the IRS website.

People often don’t remain at the same job their whole career. Should you change jobs, your 401k loan balance typically is due within 60 days.

Retirement Accounts are Protected from Creditors

An argument in favor of bankruptcy over borrowing from retirement is that the funds in your designated retirement accounts are protected from creditors.

In many states – including Florida – annuities also are protected from creditors, according to Florida Statute 222.21.

Ask a Professional about Filing Bankruptcy vs. Using Retirement Funds

When in doubt about how to proceed, contact your bankruptcy attorney and your financial advisor.

September 2020