Retirement accounts are protected from creditors and lawsuits most of the time, but not all the time. You should know the circumstances when an IRA or other retirement account might be vulnerable.
In general, qualified retirement accounts are protected from creditors, whether or not bankruptcy is declared, by the federal Bankruptcy Abuse and Consumer Protection Act of 2005.
For most types of retirement plans, the protection is unlimited. But IRAs receive limited protection with the protected amount adjusted for inflation every three years. Currently, up to $1,512,350 of an IRA is protected.
There’s no limit, however, when the IRA was funded entirely with rollovers from a qualified employer plan, such as a 401(k). So, if you have a large 401(k) and want to ensure it is protected from creditors in the future, don’t roll it over to an existing IRA that has contributions other than rollovers from employer plans. Roll the 401(k) over to a separate IRA whose only contributions are employer plan rollovers.
Another limit is that inherited IRAs aren’t protected from creditors under the federal law. In addition, a spouse can be awarded a share of an IRA in a divorce.
Plus, the IRS generally can attach a lien to an IRA as payment for overdue amounts owed to it.
But that’s not the end of the story. Each state has laws governing the extent to which retirement accounts and other assets can be reached by creditors either in bankruptcy or outside of a bankruptcy action.
Many states fully protect IRAs and other retirement plans from creditors. Your state might provide your IRA more protection from creditors and lawsuits than federal bankruptcy law does.
Even inherited IRAs are fully or partially protected in some states, though other states have limited or no protection for inherited IRAs.
Keep in mind that an IRA beneficiary might currently live in a state that protects inherited IRAs. But if the beneficiary moves to a state in which the inherited IRA isn’t fully protected, the IRA could become fully or partially vulnerable.
When an IRA is subject to creditor claims, that’s not the end of the bad news. If a creditor seizes or forces a distribution from an IRA, that’s considered to be a distribution to the owner, even if he or she never touched the money. The distribution is included in the owner’s gross income. An owner younger than age 59½ might also have to pay the 10% early distribution penalty.
To learn how well protected an IRA or other retirement account is, you have to check both federal and state law. Some people who are especially vulnerable to lawsuits decide to move to a state with more protection for their IRAs.
Another option is to distribute the money from the IRA, pay any taxes, and restructure how the after-tax amount is held.
You could move the money to a vehicle with greater asset protection in your state, such as a trust or family limited partnership. You might use the after-tax amount to buy a permanent life insurance policy. Or you could begin giving the money to loved ones who are less vulnerable to potential claims from creditors and lawsuits than you are.
If an IRA beneficiary’s creditors are your concern, consider naming a trust as the IRA beneficiary and have the individual named beneficiary of the trust. In most states this structure provides additional creditor protection. But a trade off is the trust could trigger higher lifetime income taxes on distributions from the IRA.