By Jim Glass, JD
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Suppose you unexpectedly incur a major liability, from a lawsuit or some other unforeseen cause. Will the funds in your IRA be protected from your creditors? Maybe ... or maybe not. Here are the rules:
Federal Law Protection
If you own an IRA that you've funded yourself with annual IRA contributions, then its complete value very likely will be protected from creditor claims if you are forced into bankruptcy.
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2018 protects $1,283,025 of IRA funds from creditors in bankruptcy by exempting that amount from the bankruptcy estate that is within creditors' reach. This dollar amount is adjusted every three years for inflation, and will be re-set next in 2019.
In addition, employer-sponsored SEP IRAs and SIMPLE IRAs are fully protected in bankruptcy. This matches the protection given to other employer-sponsored retirement plans, such as 401(k)s.
Moreover, funds rolled over into an IRA from an employer-sponsored qualified retirement plan, such as a 401(k), and the earnings on them, also receive full bankruptcy protection. Tip: Although not specifically required by law, keeping these funds segregated from others in a separate IRA makes it much easier to account for them should the need arise due to bankruptcy.
These combined amounts should cover all the IRA funds that you've saved for yourself, since they protect all funds obtained through employment, while your additional annual contributions and the earnings on them are very unlikely to exceed $1,283,025.
The Limits of Safety
But if you received your IRA funds as a beneficiary of an inherited IRA, these BAPCPA protections do not apply. The US Supreme Court has ruled unanimously that BAPCPA protection is available only for "retirement savings", and that IRA funds are retirement savings only for their original owners -- not for heirs who can withdraw and spend them at any age. (Clark v. Rameker, 134 S. Ct. 2242.) For inherited IRAs, protection in bankruptcy depends on state law, and different states have adopted different rules on this issue.
Planning: If you intend to leave a large amount to an heir as beneficiary of your IRA, consult with a state-law expert about the advisability of doing so through a trust arrangement that will provide protection from creditors.
In addition, outside of bankruptcy, federal law provides no protection for IRAs against general creditor claims. Again, state law will determine the degree of protection, if any, that an IRA will receive from creditors.
So if you have an inherited IRA, or you face potential creditor claims that are large but seem short of forcing you into bankruptcy, examine the protection for your IRA that is available under state law by consulting with a state-law expert.
Strategy: Should you face a large liability and find your IRA is not protected by state law, consider a voluntary declaration of bankruptcy to save your IRA using federal law. In one recent case an individual who owed creditors $127,000 owned only one major asset, an IRA worth $691,346 - enough to pay off his debts more than five times over. By declaring bankruptcy he put the IRA beyond his creditors' reach, and left them with only a 1% recovery. (In Re: Chaudury, Bktcy Ct TN, 121 AFTR 2d 2018-606.)