The Ins and Outs of Bankruptcy

Why this do-over on debt might work for you — and why not

A sign with an arrow pointing left to U.S. Bankruptcy Court in lower Manhattan

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Linda Stern

En español

Published July 12, 2021

Has the pandemic piled so much debt on you that you're wondering whether you ought to file for bankruptcy? If so, that's not surprising. In the wake of coronavirus-related business shutdowns and job losses, personal bankruptcy filings spiked this year, with nearly 80,000 Americans hoping to erase some or all of their debts.

That leap could portend an ongoing wave of filings, including among people over 65 — who, in the years leading up to the pandemic, had been the fastest-growing age group of bankruptcy filers. The combination of high medical bills, limited retirement income and the lack of guaranteed pensions makes that trend likely to continue, says Robert Lawless, a law professor at the University of Illinois. “The COVID epidemic hasn't made that any better,” he says.

But the fresh start enabled by bankruptcy is not the walk in the park some attorneys’ advertisements would have you believe. And it has implications for older Americans that may surprise you. Here is what you need to know.

Two paths to take

If a person seeks bankruptcy protection, it's generally under one of two sections, or chapters, of U.S. bankruptcy laws. Most individual filings go through Chapter 7, which wipes out debts, often at the cost of your home and your nonretirement assets. You'll typically pay between $1,000 and $2,000, including attorney's fees, to file, and can only file if your income falls below certain limits, such as the median income of a same-sized household in your state. Chapter 13 could cost three times as much, and it wipes out your remaining debts only after you've carried out a three- to five-year payment plan without any missed payments or mistakes. You'll be expected to use your income, including retirement account withdrawals, to pay off debts, but Chapter 13 will typically protect your home. To help make a decision whether to file, you can find a specialist in your own state via the National Association of Consumer Bankruptcy Attorneys and ask for a free consult.

How filing can help

It can salvage your retirement. Filing can wipe out credit card balances, medical bills and other debts, giving you more of a chance to save for retirement and more protection for what you've saved already. While pensions, 401(k)s and recent Social Security benefits are shielded from creditors even if you don't file, bankruptcy adds protection for up to $1.36 million in IRAs, which are not always off-limits to creditors in all states.

A bankruptcy filing is often the first step to an improved credit score. Even though a bankruptcy filing will stay on your credit report for seven or 10 years (where it might be held against you if you're applying for a job or trying to rent an apartment), “It is not the end of the world,” says Jenny Doling, a Palm Desert, California, bankruptcy attorney. “You can establish credit fairly quickly.” (That's not always good news, however; see below.)

You might be able to leave more money in your retirement accounts to your heirs if your debt is discharged via a bankruptcy filing. Otherwise, creditors — not your heirs — would get first dibs on any money in your estate.

And bankruptcy can provide peace of mind. Filers usually start feeling embarrassed, no matter how often they are reassured that it is a business decision and that there's no shame in being battered by hard times. But afterward comes relief, say bankruptcy attorneys who have seen this pattern repeatedly — relief both from debt collectors and from the anxiety that often accompanies overwhelming debt. As Lawless puts it, “Making the phone stop ringing is more important than a lot of people realize.”

What bankruptcy can't do

If you owe money on student loans, don't expect bankruptcy to help. Those debts, whether you took them out for yourself or your kids, are hardly ever eliminated in bankruptcy; your federal tax refund and a portion of your Social Security benefits can be taken to repay the debt once the current pandemic-related reprieve ends on Sept. 30. You also can't use bankruptcy to wipe out debts owed for child support, alimony, car loans (though you may be allowed to keep your car in some situations) or most taxes.

Depending on your state, bankruptcy may not enable you to keep your home. Laws vary wildly: California recently enacted legislation allowing you to protect as much as $600,000 in home equity. At the other extreme, Illinois might shield as little as $15,000 of your home equity when settling your debts.

Bankruptcy doesn't always work as hoped. In 2020, 27 percent of Chapter 13 filers lost bankruptcy protection for failure to fulfill their repayment plan, according to court statistics — an outcome that put them back at square one, albeit out their attorney fees. In areas that included Atlanta, Dallas and Philadelphia, that failure rate was at least 39 percent.

Finally, bankruptcy doesn't necessarily protect you from falling into debt again. In fact, your mailbox is likely to be full of credit card offers the day your debts are discharged. Why? Once you file a Chapter 7 bankruptcy, you're not allowed to file again for several years. In lenders’ eyes, that can make you a juicy source of fees and interest payments for quite some time.

Linda Stern, former Wall Street editor for Reuters, has been covering personal finance since the 1980s.

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