Protecting assets from creditors in times of economic hardship
If a client is unable to pay a debt, their creditors may resort to legal action to get what they’re owed. And if this action is successful, the consequences for a client can be devastating. A legal ruling in favor of a creditor may lead to seizure of a client’s assets and ruin their creditworthiness—potentially preventing them from borrowing for years to come. And bankruptcy, although a more orderly process than individual creditor lawsuits, can also leave a client with little more than what they need to survive. Although several years of steady economic growth caused the total number of bankruptcies (personal and business) to decline through 2019, the potential for a tidal wave of new bankruptcies under current economic conditions is quickly becoming a concern.
Simply put, the incidence of financial hardship is sensitive to the state of the economy—it rises with unemployment. And while some assets, such as a primary residence, are mostly out of creditors’ reach under different state laws, others, such as ordinary investment accounts, may be accessible.
Retirement accounts are different. Unlike other investment assets, they generally get special protection from creditors under federal law and, in some cases, state law; however, because not all retirement accounts are covered equally, the accessibility of a client’s assets to creditors depends on the type of account they’re in.
ERISA provides special protections from creditors for qualified retirement plans
The Employee Retirement Income Security Act (ERISA) keeps qualified plans and welfare benefits, such as HSAs, out of reach of creditors in most circumstances, mainly because of the anti-alienation clause, which states that your rights to the benefits can’t be taken away. 401(a) profit-sharing, 401(k), 403(b), nongovernmental 457, defined benefit, and SIMPLE 401(k) plans, as well as SIMPLE and SEP IRAs, are generally out of reach of creditors—with four exceptions:
- Payments awarded to a former spouse or other alternate payee under a qualified domestic relations order
- A lien imposed by the IRS for nonpayment of taxes
- Federal criminal fines or penalties
- Civil or criminal judgments for damage a participant caused to a retirement plan
Once assets are withdrawn from an ERISA-qualified plan, they lose the shield provided by this federal law. The one exception is assets in an IRA that consist only of qualified plan rollover money—those assets remain safeguarded from creditors, but protection is under federal bankruptcy law.
IRAs also offer protection from creditors, but with limits
IRAs are protected from creditors by federal bankruptcy law under the following circumstances:
- If the entire IRA balance came from a qualified plan rollover, or
- For an amount up to $1,362,800 (as of 2019 and indexed for inflation every three years thereafter) for deductible and Roth IRA contributions and earnings on those contributions. This amount doesn’t include employer plan rollovers.
Inherited IRAs—those received by a client as a beneficiary of an account—are not protected from seizure under federal law, although some states may offer them protection.
State laws govern protection from creditors in IRAs and vary from state to state. IRA account holders should check with the state in which they reside to learn about specific creditor protections offered by their state.
Talk to clients about protecting their retirement plan accounts
Lawmakers at the federal and state level recognize how important retirement plans are to the financial security of Americans and have, therefore, granted retirement plan assets many types of special treatment—including protection from creditors. ERISA-qualified plans are mostly safe from seizure, with limited exceptions. In cases of bankruptcy, IRAs funded exclusively with qualified rollover money and certain other IRA assets up to a specified dollar limit (as mentioned above) are also shielded from creditors. State laws may also offer some creditor protection. But once your client withdraws funds from an ERISA-qualified plan, their assets may become vulnerable to creditors. So be sure to talk to your clients about protecting their retirement plan assets before they take a withdrawal. And, if they have creditor worries, have them speak with an attorney.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
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