Many times, as clients reach the point of filing either a Chapter 7 or Chapter 13 bankruptcy, they have already exhausted all other sources of cash, such as cashing out or borrowing against retirement plans. As many clients cash out their 401(k) accounts, they could be creating negative tax consequences.
On the other hand, many clients take out 401(k) loans with the intent of repaying them in the near future to avoid the negative tax consequences. This also creates an issue in a bankruptcy filing, as 401(k) loan payments cannot be used as an allowable deduction on the means test.
Generally, 401(k) plans are considered "exempt" or protected property in a Chapter 7 or Chapter 13 bankruptcy. Therefore, it is often not a good choice in exhausting 401(k) plans as a last effort in avoiding bankruptcy. If you are in this financial situation, you should seek the advice of a bankruptcy attorney before touching any your retirement plans.