If you are facing bankruptcy, you should know that your IRA actually has more protection under the new bankruptcy law that went into effect in October. The new law generally makes it tougher for people to protect their assets, but an IRA comes out shining.
Under the new law, titled the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPA), up to $1 million of assets held in a traditional IRA or Roth IRA will be exempt from the IRA owner’s bankruptcy estate. Moreover, the IRA assets that come from an employer retirement plan rollover (such as a 401(k), 403(b), or profit-sharing plan) will not be subject to the claims of the IRA owner’s creditors, regardless of the state in which the IRA owner resides or the value of rollover assets and their subsequent growth.
More good news: the new law also reinforces the unlimited protection for 401(k) plans, 457 plans, 403(b) plans, governmental plans, and tax-exempt organization retirement plans, and adds to the list exemptions from the bankruptcy estate for SEP-IRAs, SIMPLE IRAs, Keogh plans and solo 401(k) plans. This bodes well for retirement accounts, which will become even more attractive as savings vehicles over the next few years due to their unlimited bankruptcy creditor protection.
Keep in mind, though, that not all facets of IRAs gain protection under the new law. For instance, required minimum distributions, 72(t) distributions, and hardship distributions are not protected. Also, in general, once money is withdrawn from a plan it is no longer protected. The protection also does not apply to judgments awarded in other courts where state creditor protection laws will apply. And BAPA will not stop a divorcing spouse from taking a share of the pension.
Prior to the new law, there was much confusion over determining how a person’s IRA would be exempt from claims of his or her creditors if they filed for personal bankruptcy. There was such a confusing mix of federal and state laws and court cases that a person did not know whether or how much of his/her “rollover” IRA would be subject to claims of creditors. This all changes under BAPA. Interestingly, IRA owners who live in states that have poor IRA creditor protection benefit most from the new law.
You still need to do your record keeping and stay on top of your investments. For example, you should keep your IRAs that are funded with rollover contributions separate from IRAs funded with annual contributions. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 made obsolete the need to create a conduit IRA, but BAPA provides an incentive to have separate IRAs – both an IRA funded with rollovers and one funded with contributions. To commingle rollover and contributory IRA assets would make it difficult to identify which portion of the IRA represented assets that are “unlimited protection” rollovers (plus earnings) and which portion represented IRA contributions and earnings (subject to the $1 million limitations).
The new law also encourages investors to roll over their 401(k) to an IRA after they leave an employer. Prior to the new law, investors often left their funds in their former employer’s 401(k) plan since such plans were fully protected from bankruptcy. But now 401(k) plans and IRAs have near equal protection from creditor claims, so there’s less reason to leave such funds behind.
Instead, there are some good reasons to transfer funds from a 401(k) to an IRA. For instance, doing so not only broadens your investment options but also may open the door to create what some refer to as a “stretch IRA,” an IRA that continues to grow tax-deferred over the life of its beneficiaries. If you choose to leave your money in a 401(k) plan, that money in most cases must be immediately distributed to your beneficiaries after your death.
On the other hand, some good reasons exist for leaving your money in your 401(k). For instance, qualified retirement plans are protected under ERISA, which extends to judgments other than bankruptcy, regardless of your state law.
Like all new laws, BAPA will likely be challenged at some point by creditors in the courts. A financial planner and a bankruptcy attorney will be able to advise you on future actions, but you should also frequently review any legal challenges and clarifications issued by federal authorities including the Internal Revenue Service (IRS) or Department of Treasury.