Your Retirement Account May Not Be As Safe As You Think
Many people don’t even think about experiencing a lawsuit or a bankruptcy. That’s understandable since for most of us these are highly unlikely events. Unfortunately in the time of COVID the prospect of bankruptcy has become unexpectedly real for many small business owners. And the risk of being sued is no farther away than fumbling with your mobile phone while driving and accidentally striking another car. Or worse, a pedestrian. You might be surprised to learn that safeguards against creditors tapping into your retirement accounts as a result of lawsuits or bankruptcies differ depending on the type of account and the state in which you live. And those safeguards may be weaker than you thought.
Let’s start with bankruptcy. All retirement plans except for traditional and Roth IRAs provide unlimited protection. In other words, if you do declare bankruptcy, none of the money in such plans can be touched by bankruptcy creditors. The protection for IRAs is subject to a cap that is indexed for inflation. In 2020 you can keep up to $1,362,800 of savings in IRA accounts after going bankrupt. Even better, if you had previously rolled over savings from an unlimited-protection plan such as a 401(k) into your IRA, the amount rolled over retains its original unlimited protection.
One interesting exception are inherited IRAs. The U.S. Supreme Court ruled in 2014 that they are not protected at all in bankruptcy because they are not considered to contain retirement savings.
It gets more complicated regarding general creditor lawsuits. Plans sponsored by the Federal Employee Retirement Income Security Act (ERISA) provide unlimited protection against creditors. These include company 401(k) plans, profit-sharing plans, employee stock plans, and pensions. (This is partly how O.J. Simpson was able to hang on to much of his wealth despite having lost a $33 million wrongful death lawsuit brought by the family of his murdered ex-wife). Non-governmental 403(b) plans may or may not be included depending on the employer’s adherence to ERISA rules.
What about the other retirement plan types? Individual (also called solo) 401(k) plans, non-ERISA 403(b) plans, SEP and SIMPLE IRAs, as well as both traditional and Roth IRAs, do not have the same general creditor protections as those above. Instead their level of protection is based on individual state law. Some states such as Texas provide the same unlimited protection as that provided by federally-sponsored plans. Others such as New Hampshire have no protection laws at all. California will shelter only the amount of money in your IRAs deemed necessary to support you and your dependents in retirement. But exactly how much that should be will be decided by a judge on a case-by-case basis. And it will certainly not include any amounts that you may have been hoping to pass on to your children or others after you die.
If you have a self-directed IRA that invests directly in more esoteric assets such as real estate or other businesses, it’s important to make sure those assets are owned within an LLC. That will protect the rest of the IRA against any judgements made against the LLC.
Whenever you leave a company with a 401(k) you will be faced with the decision as to what to do with it: leave it alone, roll it over into another 401(k), or roll it over into an IRA. Creditor protection is only one of many factors you should be considering. Make sure you (or your advisor) fully understand all the ramifications before making your choice.