Are Your Retirement Accounts Creditor Proof?

Even if you aren’t worried about getting sued right now, it’s nice to know what is within the reach of creditors and what is out of bounds.

If you have money in a 401k you can relax – your assets are safe from nasty creditor law suits. The same goes for SEPs and SIMPLE IRAs. These are all employer sponsored plans and as such exempt from lawsuits. That’s because employer sponsored plans are covered by the Employee Retirement Income Security Act, known as Erisa.

IRA money isn’t covered by ERISA but that’s OK. The first $1,245,000 in your IRA is also protected in case of bankruptcy. Since most people don’t have that much in their IRA, it’s not a problem either.

The Exceptions

First, you may have noticed that there is a difference between employer sponsored plans and IRAs as determined by Federal law. The former is exempt from all creditor lawsuits with IRAs are only sheltered in case of bankruptcy. And there are other exceptions as well.

First, if the IRS slaps a tax lien on you, you are out of luck. The Government can and will go after every nickel you have. They will leave no stone unturned.

Also, if you embezzled money out of an employer plan, its open season on all your assets – so let’s keep it clean Pilgrim.

And last but not least, let’s not forget about your spouse. In a divorce, your ex can easily claw away a good chunk of your retirement accounts – regardless of what kind of account you have the money in.

The Biggest Exception

If you own an Inherited IRA, you have no lawsuit or bankruptcy protection at all. That’s because the Supreme Court ruled unanimously this year that Beneficiary IRAs are more akin to investments than retirement accounts. No protection for you!
(Whether or not that means that IRAs the spouses inherit from each other fall under this exception or not remains to be seen. )

Your State May Provide More IRA Protection

As I said above, Federal law provides no protection for your IRA money outside of bankruptcy. But your state may be more hospitable. Some states like New York and New Jersey protect all your IRA dough against creditors. California on the other hand keeps it nice and vague. They extend a limit to what is “reasonably necessary” to support the owner and his dependents. That’s practically an invitation for a law suit.

The Solutions

Given that anyone can sue anyone anytime for any reason, what’s an investor to do?

One option is to leave your money in your 401k or even roll over your IRA to your employer plan. That gives you more protection for sure. But in this case, the cure may be worse than the disease.

That’s because with the 401k you have fewer investment choices, less flexibility, higher fees and limited access.

A better approach might be to buy the right liability insurance like a good umbrella policy and professional liability and malpractice coverage if you are self-employed. You can buy a lot of coverage for very little money in most cases. If you go that route, you just don’t have to worry about it. Inexpensive solution for a lot of sleep at night. Cool.

When it comes to Beneficiary IRAs, you might consider setting up a trust to inherit the assets – but tread carefully. The attorney who drafts this document must really know what she is doing and use the proper language.

The key is to draft the document in such a way that allows the beneficiaries to continue deferring the payments for as long as possible on the one hand and protect the assets from creditors on the other hand. That takes a sharp legal mind.

There are other drawbacks to this approach. If you name a trust as the beneficiary of the trust, the beneficiaries of the trust will be forced to accelerate their withdrawals. That means they will pay taxes faster than they otherwise might have to. They will probably also have to pay higher legal fees at the same time.

The bottom line on creditor protection is that for most of us, a good liability policy should do the trick. If you face identified risks or have other special circumstances, you might need to take some of these special steps. If so, make sure you seek out expert legal counsel.