Creditor Protection For IRA Accounts

Last week, I discussed the new bankruptcy law signed by President Bush and how the law would make it much more difficult for people to wipe out their debts by filing Chapter 7 bankruptcy.  Under the new regulations, in most cases, they will be forced to go on a repayment plan (Chapter 13 bankruptcy).  An important aspect of the law bears a follow-up discussion.  In the past, the level of protection afforded IRA accounts was determined by each state. In Alabama, for example, state legislators have failed to take a position on this subject, therefore leaving to the courts to decide on a case by case basis.  The result has been conflicting court cases whereby a creditor was able to successfully attach IRA assets in the southern part of the state while the IRA assets were protected in a case in the central part of the state.  Many other states protect IRAs as a matter of state law.

Earlier this month, in the case of Rousey v. Jacoway, the U.S. Supreme Court ruled to extend creditor protection to IRA accounts in bankruptcy proceedings.  Many professional advisors incorrectly assumed that this meant full-scale creditor protection for IRA accounts.  While the ruling did ‘set the boat afloat’, close inspection suggests there are a number of holes allowing plenty of water to seep in.  The ruling appears to attach a ‘needs’ test to the amount of IRA assets that would be sheltered from creditors. In addition, the language in the ruling addresses issues specific to Traditional IRAs including the 10% early withdrawal penalty prior to age 59 ½ and the Required Minimum Distribution (RMD) rules at age 70 ½.  Therefore it appears the Roth IRA is unaffected by the ruling, leaving it potentially subject to the claims of creditors.

That leaves us with the new bankruptcy law and its impact on these accounts.  Traditional and Roth IRA assets will now be creditor protected under federal law for up to $1,000,000. Most importantly, assets in an IRA account as a result of being ‘rolled over’ from qualified plans such as a 401k or profit sharing plan receive unlimited creditor protection. For example, let’s say you are a recently retired physician and that you made annual contributions to your IRA account each year for the past 25 years and it is now worth $325,000.  Now you ‘roll-over’ $1,500,000 from your profit sharing plan bringing your total IRA account value to $1,825,000.  You are sued and the plaintiff receives a judgment of $3 million.  What is the risk to your IRA account?  None.  Your regular contributions to your IRA are protected up to $1 million while your rollover contributions are protected without limit.  This is true whether the IRA is a Traditional IRA or a Roth IRA.  This is great news because it resolves one of the long-standing concerns held by many IRA owners.  It also draws attention to two issues:
1. Investing in retirement plans, whether your company 401k or your personal IRA, is more important than ever.  It’s a place you can confidently invest assets without concern about future creditors.
2. It is vital that you maintain complete and accurate records since you will now want to be able to distinguish between personal contributions to your IRA versus rollover contributions from qualified retirement accounts such as 401k and profit sharing plans.