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By Michael S. Anderson of Anderson Tax Law logo for Arizona tax attorney Michael S. Anderson P.C.
  • 401k and bankruptcy: Will the IRS seize my retirement account after my bankruptcy is over?

    401k and Bankruptcy – Post Discharge

    Scenario

     

    • The bankruptcy attorney has explained to you that the money  in your 401k plan is safe from creditors, and therefore safe from those creditors and the bankruptcy trustee if you file a chapter 7 bankruptcy.
    • You also owe the IRS some serious back income tax.  The income tax debt meets the criteria to be discharged in the bankruptcy filing.  In other words, when the chapter 7 bankruptcy is over, you won’t have a personal obligation to pay the IRS debt.
    • Several months prior to the bankruptcy filing,  the IRS recorded a number of “Notices of Federal Tax Lien” documents in the local County Recorder’s office.
    • You file the bankruptcy case.  The case goes well, discharge is entered and the case is closed.
    • Six months after the bankruptcy case is closed, you receive a letter from the IRS.  The letter states that the tax obligation was discharged, but that the IRS is enforcing it’s tax lien on your retirement account and is taking action to seize the account.
    • You are confused as you believed that the retirement account was safe and that the tax debt was wiped out.   Sleepless nights ensue.

     

    Explanation

     

    If you have serious tax debt and a retirement plan, the above scenario may be important to you.  There are a few things about the law that you need to understand:

    • Most retirement accounts i.e. 401k, IRA, 403B funds are safe or exempt in bankruptcy.  Actually, certain “ERISA” accounts aren’t even part of the bankruptcy estate.   The bankruptcy trustee has no interest in them from the outset.
    • Unlike other creditors, the IRS isn’t subject to exemption rules i.e. a percentage of social security checks and retirement accounts are theoretically fair game.
    • IRS liens properly recorded, survive a chapter 7 bankruptcy filing even if the underlying tax debt, the tax debt that was the basis for the lien was wiped out.  That tax lien survives and it is worth whatever you were worth on the date of the bankruptcy filing.  If you owned one asset worth $5000.00, like a car, and the discharged tax debt was $100,000.00, the lien is worth $5,000.00.
    • In a way, the IRS is like the lender on a car.  If you file a chapter 7 bankruptcy and you want to quit paying on the car, the chapter 7 bankruptcy will discharge your obligation to do so.  You will not be legally required to make the payment to the car lender.  The car lender however, still has a relationship with the car i.e. a security interest in it, and that security interest is worth whatever the car is worth.  When the case is closed, the secured lender can take the car as a result or request payment of the car’s value in exchange for release of the lien.  It cannot sue you for the balance or deficiency if one exists.
    • The retirement account is like the car.  In the scenario above, it is worth however far more than $5000.00.  If it were worth only $5000.00, it is highly likely that the IRS would agree to simply release the tax lien.  The amount of the tax debt was quite high though and more than the value of the retirement account, so the IRS could, at least in theory, seize the account based on the lien.

     

     

    Solutions
    Some solutions to this problem include:

    • If possible,  file the bankruptcy before the tax lien is recorded.  This can be tricky of course.  The tax debt won’t become dischargeable in the bankruptcy case for a period of time.  (See bankruptcy discharge date requirements). The IRS will try to record that tax lien notice as soon as it can where the debt is relatively large.  There are defenses to the recording of the lien, but their application is fairly narrow for large debts.
    • Remind the IRS that internal policy requires it to consider collection alternatives before levying or seizing assets.  (Although this may be changing)  Alternatives include IRS installment agreements and IRS offers in compromise.  The fact that you may have been saving money in the 401k plan while ignoring the tax may not bode well for you in this regard.
    • Prove to the IRS that you need the retirement account funds to survive or will need them in the near future.  It may be sensitive to the fact that the proceeds are paying your basic living expenses perhaps for the remainder of your life.
    • Make an offer.  Try to get the IRS to accept a smaller amount than the tax lien is worth in exchange for leaving the account in place.

    If the above scenario is familiar or you think it will be in the near future, the wisest thing to do initially is to speak with an attorney experienced in bankruptcy and tax debt matters.