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Bankruptcy may be a smart move before law changes

We're all vulnerable to financial disasters that can lead to personal bankruptcy, whether they involve natural disasters, divorce, illness, disability or death of a bread winner.

Some of the conventional advice concerning financial calamity is best ignored. Bankruptcy isn't always a good solution and it can create even more financial headaches.

Odd as it may sound, it may make sense to consider filing for Chapter 7 bankruptcy before Oct. 17, when a new law goes into effect that is more hostile toward debtors. This means you may be able to wipe out your debts and have an easier time of starting over. After that, bankruptcy will be more onerous than ever.

While the new bankruptcy law shields as much as $1 million in retirement funds, it offers less protection for every other asset, including homes and cars.

Only $5,000 per child is protected in education savings. And you can't exempt more than $125,000 in home equity unless you've resided in a state for three years and four months. I know that sounds bizarre, but this is one tough law for consumers.

Unlike the present law, the new legislation requires mandatory credit counseling, a debt-repayment program and filing of numerous forms such as tax returns, which then become public documents.

Little leeway

The new bankruptcy law is so complex and burdensome it would be difficult to negotiate under it without the services of an expensive attorney.

The focus of this pro-creditor statute is the repayment of debts. The law automatically prevents debtors from filing for Chapter 7 bankruptcy -- which can clear debts -- if you are above the median income level in your home state. Those failing to meet the income test are forced to file for the unforgiving Chapter 13 bankruptcy.

"The new law presumes that everybody who files for bankruptcy does so because of poor financial planning," said Brad Botes, a bankruptcy lawyer in Birmingham, Ala. "As anyone who's gone through a divorce, accumulated large medical bills or gone through a hurricane can tell you, that's not always the case."

401(k) withdrawals

One of your best bulwarks against financial disaster is having a money-market fund or inflation-protected U.S. savings bonds. Even loans from or cashing in cash-value life policies (if you don't need the coverage) should be considered. A last resort is a 401(k) withdrawal or loan.

Ask your employer about rules regarding "hardship withdrawals" from your 401(k)-type plan. Not all retirement programs offer this option, but if they do, you can withdraw the money for medical bills, first-time home purchase, college expenses and to prevent eviction from a primary residence.

Hardship withdrawals will trigger payment of ordinary federal income tax of as much as 35 percent, plus an early withdrawal penalty of 10 percent if you are younger than 59 1/2. That means you'll only get 55 cents on the dollar after taxes on your withdrawal if you're in the top bracket. If you're a survivor of Hurricane Katrina, the penalty will be waived for withdrawals for as much as $100,000 under new legislation.

Note that you may not be able to withdraw a dime from your 401(k) unless your plan has specific language authorizing it.


If your plan permits it, consider a 401(k) loan first, which doesn't result in income tax payment and a penalty, but must be repaid with interest over time. The 401(k) money is tax free if repaid within five years. If you change jobs, though, you'll need to repay the loan in full; otherwise you'd pay taxes and the penalty.

Also keep in mind that it will be difficult to rebuild the tax-deferred funds in your 401(k), particularly if that kitty was accumulating when annual returns exceeded more than 10 percent during the 1990s. Whether you take out a loan or withdrawal is an important distinction. Loans will put money back into your 401(k); hardships withdrawals will not.

"Once you've taken out a hardship withdrawal out of your plan, you can't put it back," said Deborah Novotny, vice president of T. Rowe Price Retirement Plan Services Inc., a branch of the Baltimore-based mutual fund firm. "And a hardship withdrawal is not a required plan provision."

A home-equity loan is worth considering as an alternative to a 401(k) loan and or running up the balances on the credit cards, mostly because the interest is tax deductible and the interest rates are lower. Just keep in mind one powerful caveat: If you don't repay this loan, you might lose your home.

Be careful

What about loading up on credit-card debt to make it through a crisis? Although this debt is not secured with any collateral -- such as your home -- it is much more costly than home-equity debt and not tax deductible. Banks also will be soon doubling minimum interest payments to satisfy concerned regulators.

If bankruptcy is your only exit route from crushing debts, talk with your creditors, accountant, attorney or financial adviser first.

Even under the current law, a bankruptcy filing will mar your credit rating for years, make it harder to get loans and otherwise complicate your life. Don't consider it unless you've exhausted all other means of paying your debts.

Wasik is a columnist with Bloomberg News

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