IRAs are among the most valuable assets many Americans own, and protecting those assets from creditors and lawsuits can be a concern. This can be a tricky proposition, because IRAs are in a netherworld of asset protection.
Protection for IRAs in federal bankruptcy court was improved by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. But IRAs still can be vulnerable in other situations.
Assets of employer-sponsored qualified retirement plan assets are protected from claims of creditors both in and out of bankruptcy actions under the Employee Retirement Income Security Act of 1974. ERISA also overrides any state laws that appear to allow creditors to reach retirement plan assets. Protected plans include defined benefit pension, 401(k), and profit-sharing plans. This protection, however, does not extend to plans that cover only the business owner or the owner and his or her spouse. Those plans are protected in federal bankruptcy actions but not in other instances. The full protection is available if nonowners also participate in the plan.
IRAs are protected in federal bankruptcy actions, but the protection varies by the type of IRA.
There is an unlimited exemption for rollover IRAs that contain assets transferred from pension, profit-sharing, and 401(k) plans as well as for SEPs and SIMPLE IRAs. The unlimited exemption for rollovers could be lost if the IRA also contains other assets. For that reason, it is best to roll over employer plan assets to a separate IRA instead of commingling them in an already-existing IRA containing individual contributions.
A traditional IRA or Roth IRA receives bankruptcy protection under the 2005 law, but not the unlimited exemption of employer-sponsored accounts. An IRA containing individual contributions is an exempt asset in bankruptcy up to $1 million (adjusted for inflation). Assets rolled over from a SEP or SIMPLE IRA probably receive the same protection limit instead of their prior unlimited protection. A bankruptcy judge has discretion to increase the $1 million limit if the “interests of justice so require.”
As a practical matter, the $1 million exemption is equivalent to an unlimited exemption. Because of the relatively low contribution limits for IRAs, an investor would need investment returns well above average over many years to breach the limit. IRAs that exceed the $1 million limit are likely to contain assets rolled over from employer-sponsored plans that are exempt if kept in a separate rollover IRA. Technically, rollover assets can be commingled with other IRA assets. The rolled over portion would have the unlimited exemption, and the other portion the $1 million exemption. But the burden would be on the IRA owner to show the principal amount of each portion plus the income and gains attributable to each portion. It is safer and easier to keep rollover assets in a separate IRA.
An account balance retains its protection while being rolled over to another IRA or qualified retirement plan. The creditor cannot successfully argue that the assets lost their protection at some point during transit.
Withdrawals lose their protection. Once money is withdrawn from a protected account, it can be reached by creditors. Even forced withdrawals, such as required minimum distributions, can be reached by creditors.
The federal bankruptcy protection, however, does not protect the assets in other situations.
A creditor could sue for failure to pay in state court and attempt to attach or seize assets or garnish wages. In such cases, federal bankruptcy law does not apply. The anti-alienation provisions of ERISA protect assets covered by it. But traditional IRAs, Roth IRAs, SEPs, and SIMPLE IRAs do not receive that protection. For these assets, the protection in such situations depends on state law.
State protection for IRAs varies considerably. A number of states, such as Ohio, fully exempt both traditional and Roth IRAs from any action to satisfy a judgment or court order and have no cap on the protection. Some states exempt traditional IRAs but not Roth IRAs. Then, there are states such as Minnesota that provide limited protection. Minnesota exempts only $30,000 plus whatever amount is “reasonably necessary” to support the debtor, a spouse, and any dependents. Nevada protects only $500,000 of retirement assets. South Carolina exempts only the amount “reasonably necessary” to support the debtor, a spouse, and any dependents. Virginia’s exemption applies only to a balance providing an annual benefit up to $17,500.
What can an IRA owner do if he or she lives in a state that provides modest protection for IRAs? There are states competing to attract IRA balances.
One alternative for people concerned about their account balances is the true self-directed IRA combined with a limited liability company or limited partnership as discussed in the May and July 2004 issues. The LLC or FLP provides protection under state law, and the creditor cannot compel the IRA owner to make a distribution from the entity into the IRA where the creditor can reach it.
A few states, especially Delaware and Ohio, created individual retirement trusts instead of custodial accounts. The trusts qualify as IRAs under the tax law but offer additional creditor protection and estate planning choices. Delaware IRAs, for example, have spendthrift provisions.
It is not clear how much protection these trusts offer. A non-Delaware court could rule that a non-Delaware resident cannot use the Delaware IRA to give assets more protection than IRAs in the state of residence.
ira trusts are more expensive and only a few Delaware institutions offer them, such as NatCity Trust Co. and Capital Trust Co. Fees at NatCity recently were 1.1% of assets, which includes asset management services. Capital Trust offers IRA trusts through financial advisors and charges 0.3% on the first $1 million, or a minimum fee of $1,250. The financial advisor normally charges additional fees.