Friday, March 11, 2016

Is My Retirement Plan Protected?

In Why Retirees Go Broke, I explained that the risk of outliving your savings portfolio and the risk of insolvency are two very different risks. In Retirement Plan or Investment Plan?, I mentioned that a retirement plan should consider protection of your assets from creditors in the event of the worst-case outcome, i.e., bankruptcy becomes a consideration, and that most retirement plans are protected, at least to some extent.

To follow up, I thought it might be helpful to create an overview of asset protections for retirement accounts. It is, to say the least, a complicated subject, as legal issues tend to be, so I teamed up with Kim Steffan, an attorney from nearby Hillsborough, NC who writes the monthly “Ask the Lawyer” legal column for the News of Orange County.

We’re going to provide an overview but you really should discuss your specific situation with an estate attorney. Protection from creditors should be part of your retirement plan but if your planner is not also an estate attorney, insist that he or she consult one.

In broad strokes, different retirement plans are protected in different ways by the Employee Retirement Income Security Act of 1974 (ERISA, a federal law), the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA, also a federal law), and by your state laws.

ERISA is a federal law that “sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans.” An employer, for example, might voluntarily set up an ERISA qualified retirement plan for its employees such as a 401(k), 403(b) or a defined benefit (DB) plan. ERISA protects individuals in these plans from creditors. Most employer plans are ERISA-qualified, but you should be able to confirm this with your plan administrator.

BAPCPA is a federal law passed in 2005 largely to limit debtor protections during bankruptcy, but that actually added protections for individual retirement plans not covered by ERISA, like traditional and Roth IRAs.

Debtors are allowed to exempt (protect) some amount of property in bankruptcy. BAPCPA defines exempt amounts at the federal level but allows states to “opt out” and define their own exemptions. Many states have chosen to opt out of the federal exemption scheme, so the laws of your state are likely to play a major role in protection of your individual retirement accounts.

Most retirement plans are protected from creditors to some extent, but protection varies by state and creditor.
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Protection of our retirement plans may vary depending on whether or not we declare bankruptcy. Some creditor protections apply only during bankruptcy while others protect our IRAs from creditors without our having to file for bankruptcy. ERISA protects our employer plan benefits in both scenarios. BAPCPA protects individual plans only during bankruptcy. Creditor protection of individual retirement plans without declaring bankruptcy is dependent upon state law and varies widely.

Michael Kitces wrote an excellent piece soon after The Bankruptcy Abuse Protection and Consumer Protection Act (BAPCPA) changed the landscape in 2005. Kitces pointed out that “a client might actually need to file for bankruptcy to protect an IRA from creditors. On the other hand, if a client's other assets or income might be treated unfavorably during bankruptcy in the client's domicile, this might not necessarily be a desirable course of action.” In other words, your IRA might not be protected unless you declare bankruptcy and bankruptcy might have undesirable consequences for other assets.

Protections for non-ERISA plans like IRAs also need to be sorted depending upon whether they were created by a rollover. Rollovers from a qualified employer plan to an IRA inherit the unlimited protections of their former ERISA plan. SEP and Simple IRA plans are treated like employer plans, but if they are rolled over to an IRA they are then treated as individual plans and may have less protection from creditors.

According to the National Institute of Pension Administrators (download PDF),
There are both federal and state exemptions that might apply to a debtor. States are permitted to opt out of federal exemptions and define their own. These state exemptions vary widely. The Bankruptcy Code allows debtors to claim certain property as exempt, using either exemptions allowed under state law, or exemptions provided in the Bankruptcy Code. While this choice is available in a few states, the majority of states mandate that debtors use only the exemptions provided under state law.
When I searched for bankruptcy exemptions in my home state, North Carolina, I learned from NOLO that “North Carolina debtors must use state exemptions.” Also, IRAs and Roth IRAs have an unlimited exemption under NC state law. You need to check your state laws to see when state and federal law applies. Here’s a summary chart from The Tax Adviser of exemptions by state (download PDF), but it doesn’t provide everything you need to know.

Protection from creditors without declaring bankruptcy is a matter of state law. According to Kim Steffan’s website, for example,
The good news [for North Carolinians] is that retirement accounts which you fund while you are working are generally safe from most creditors. N.C. General Statute section 1C-1601 covers what assets creditors can seize and sell to satisfy judgments – a topic which is entirely separate from filing bankruptcy, by the way. Under that statute, money in your 401(k), traditional IRA, Roth IRA, and/or 403(b) is protected . . . NC law doesn’t put a dollar limit on protection of retirement assets for those who do not file bankruptcy. Your contributions to your employer’s pension plan (like the N.C. State Retirement System) are also safe, but for a different reason – because they are held by the pension plan and are not assets in your name.
Again, the key point is to check state law for your IRA protections from creditors both during and outside bankruptcy.

One relatively new development is that the Supreme Court ruled in 2014 that An Inherited IRA Is Not A “Retirement” Account For Bankruptcy Protection (another excellent summary by Kitces). The theory is that if you inherit your father’s retirement account, though it was a retirement account for him, it’s just a normal inheritance for you. Yet another development is the concern that “stretch IRA’s” are endangered, as described in this interview with IRA expert, Ed Slott.

My best shot at simplifying this morass is the following table.

Retirement Account Protection from Creditors

During Bankruptcy Outside Bankruptcy
Account Type Federal Protections North Carolina Protections [2] Federal Protections North Carolina Protections [2]
Qualified ERISA Plans
401(k), 403(b), Defined Benefit Plans, Profit Sharing Plans, Deferred Compensation Plans Generally Unlimited [4,5] Generally Unlimited [4,5] Generally Unlimited [4,5] Generally Unlimited [4,5]
IRA Plans Protected by BAPCPA
IRA (ERISA Plan Rollover) Unlimited [4] Unlimited per NC Law Generally Unlimited [4] Unlimited per NC Law
Traditional IRA $1,245,475 [1] Unlimited per NC Law None Unlimited per NC Law
Roth IRA $1,245,475 [1] Unlimited per NC Law None Unlimited per NC Law
Simple IRA Generally Unlimited [4] Unlimited per NC Law None Unlimited per NC Law
Simple IRA Rollover $1,245,475 [1] Unlimited per NC Law None Unlimited per NC Law
SEP IRA Generally Unlimited [4] Unlimited per NC Law None Unlimited per NC Law
SEP IRA Rollover $1,245,475 [1] Unlimited per NC Law None Unlimited per NC Law
Keough Generally Unlimited [4] Unlimited per NC Law None Unlimited per NC Law
Protection of Other Retirement Assets
Contribution to Employer Pension Plan Unlimited [3] Unlimited [3] Unlimited [3] Unlimited [3]
Distributions from Plans (incl. RMDs) None None None None
Inherited Plan None None None None

[1] This amount under BAPCPA ($1M) is adjusted every three years for inflation and was $1,245,475 as of 2013.   
[2] Protections vary widely by state.                   
[3] Contributions are safe because they are held by the pension plan and are not assets in your name.       
[4] There are some circumstances when a creditor can still get to your ERISA benefits. That includes seizure by: your ex-spouse under a Qualified Domestic Relations Order (QDRO), to the extent of your spouse's interest in those benefits as a marital asset or as part of a child support attachment.
[5] State law superseded by ERISA protections.

As you can imagine from the table above, it may be simpler to consider which retirement plans might be at risk, as opposed to identifying which are protected. Consider the following:

  • Retirement accounts that you have inherited are not protected from creditors.
  • Individual retirement accounts are protected under BAPCPA only to an aggregate amount of $1,245,475 (total balance of all your individual retirement accounts), but state law may provide more protection. For example, in NC, protection is unlimited by state law.
  • SEP and Simple IRA accounts receive unlimited protection under BACCPA, but IRA’s from rolled-over SEP and Simple IRA accounts are protected under BAPCPA to an aggregate amount of $1,245,475. They may, however, have greater protection under your state law.
  • Your retirement plan is not protected from claims from government creditors, or judgments needed for paying alimony or child support.
  • Distributions from retirement plans, including Required Minimum Distributions, are not protected.
  • Individual retirement plans are not protected outside of bankruptcy by federal law, but may be protected by your state law. Exception: IRA’s created from rollovers from ERISA plans are federally protected.
  • Government and church retirement plans are not protected from creditors.
These issues are quite complicated, which is the point of this post. However, as I pointed out in recent posts, about half a percent of Americans over the age of 65 declare bankruptcy at some point, usually early in retirement. It’s important to consider protecting your retirement accounts from creditors.

Nor is bankruptcy the only concern. You may wish to protect assets from creditors and judgments without declaring bankruptcy. These protections are separate from those in bankruptcy.

What should a retiree do?
  • Use the information in this post to better understand your asset protections and then discuss them with a qualified attorney and your financial planner.
  • Several sources suggest that you create a separate account to receive your Social Security benefits payments to avoid commingling the funds and maintain their exemption. Similarly, several also suggest you create a separate IRA account to roll over an ERISA plan.
  • Find out if your state has opted out of the federal exemption scheme. (Google, for example, “Kentucky Bankruptcy Exemptions NOLO.”) If your state has opted out, determine what protections your state provides for individual retirement accounts. Use this form to record the information.
  • Develop a list of your retirement accounts, the type of plan (401(k), IRA, Roth IRA, etc.), and the balance of each for your accounts and your spouse's. Use the same form above to record the information.
  • Discuss these accounts with a qualified estate attorney. Prepare yourself by studying your state’s bankruptcy laws regarding IRAs and other non-ERISA plans.
  • Ask your attorney if those unprotected plans might be protected in some way.
  • Don’t roll over your SEP and Simple IRA’s without determining the possible loss of protection from creditors in your state.
  • Modify your retirement plan accordingly.

Check your state's retirement plan creditor protections and discuss them with a qualified attorney and your financial planner. About a half percent of Americans declare bankruptcy after reaching age 65. In the unlikely event it happens to you, or you are subject to a judgment, you’ll be happy that you did what you could to protect your assets.

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  1. This is a great topic - one that I have fretted over from time to time, each time becoming frustrated to the point of inaction. I am curious about the protection for rollovers from a 401(k). I had a 401(k) once upon a time, but have consolidated the collection of funds I once had into a few Vanguard funds. I believe most of the traditional IRA account came from that rollover, but I had some traditional IRA accounts outside of my employer plan at one time. Have I lost all protection by combining protected and unprotected retirement funds? If not, yay - but I imagine that determining the current value from each source is a headache I will contemplate only if I find myself in the position of needing to know.

    Also, I have contemplated buying an umbrella policy in order to protect my retirement funds but am wary of the insurance industry in general, I'm wondering if anyone has experience or insight on this strategy?

    1. Your first question is a legal issue, so perhaps Kim will respond. Based on what I have read, you have not lost all protection but you will have the headache you describe should it come to that – hence, my recommendation to create a separate account for rolling over ERISA plans and to not commingle the funds. I'm not a lawyer and this shouldn't be construed as legal advice.

      I assume you are referring to an umbrella liability policy. I have one. They're quite affordable. It will protect you from liability, not creditors. If the debt is due to a judgment from an insured liability, a policy should protect you, but it wouldn't protect you, for example, from huge medical bills.

      Bottom line, I like umbrella liability policies to protect against potential judgments, but they don't insure bankruptcy risk from other sources.

    2. In answer to your first question, as we lawyers like to say, it depends. If you live in NC or in another state with unlimited protection for IRAs and rollover IRAs that represent savings made toward your retirement (as distinguished from an inherited IRA), your rollover IRA funds are protected. If you took them as a distribution and commingled with non-retirement savings, then they would no longer be protected, but I understand your question to be with a rollover rather than a distribution. If you live in a state that does not have unlimited or other favorable protection by state law, you will still have protection in the rollover fund in bankruptcy up to $1,245,475 aggregate.

  2. Dirk, excellent post, and timely for us. We are in the process of purchasing a home (after looking for 7 yrs yes 7 yrs). I needed to access some funds, and decided my 401K was the best option. I had heard/read that as you mention segregating the money rolled from my 401K to Trad Rollover IRA account would continue the ERISA protections provided the 401K. This is what I plan to do, and should I subsequently convert some of this Trad IRA money to a Roth Rollover IRA I have already established a segregated Roth Rollover account separate from my annual Roth contribution account.

    Unfortunately, when Ann took a new position about 18 yrs ago she rolled the money she had in her prior employer's 401K into a Traditional IRA account, but then as she converted it to a Roth over time she rolled the money into an existing annual contribution Roth account thereby commingling the the prior ERISA 401K money with her annual Roth contribution account. She lost the ERISA protection. This was a great article Dirk. Thanks for providing a lot of useful information in one article. Brad