IRAs May Be Vulnerable in Personal Bankruptcy

By Clifton Linton
Senior Writer, mPower

In This Story Time Travel Protection Trends Strongest and Weakest Protections

If you declare personal bankruptcy, retirement money in an IRA account could be seized by creditors. While federal laws universally prohibit creditors from touching retirement money in employer-sponsored plans, a patchwork of state laws controls individual retirement accounts.

The good news is that over the past few years, many state legislatures have been expanding protections.

minute: read this article at a glance.

Technical Terms Employee Retirement Income Security Act (ERISA) Roth IRA Conduit IRA

Most people think about bankruptcy in the same fashion they think about disease: It is something that happens to somebody else.

The truth is that financial tragedy could strike at any time and force anyone to seek bankruptcy protection. If that isn't bad enough, those money troubles could easily extend into retirement. The reason: Depending on the state in which you live, retirement assets held in IRA accounts could be vulnerable to creditors.

State laws, not federal, dictate IRA protections in the event of personal bankruptcy. And, as you can imagine, there are as many different bankruptcy treatments for your IRA money as there are states.

This means if you have a large (or even a modest but growing) IRA account balance, you need to figure out what protection your state offers. Because these protections often are buried deep within state laws, this may not be an easy task. But, resources are available to help you.

Let's take a look at how the laws developed, which states have historically offered some of the strongest protections and where to go to find out the rules in your state.

Time Travel

The best way to understand why IRAs are often susceptible to creditors (while employer-sponsored plans are not) is to travel back in time to 1974. That was the year Congress passed two laws: Section 408 of the IRS tax code, which created IRAs, and the Employee Retirement Income Security Act (ERISA).

ERISA was initially set up to protect defined-benefit programs (like pensions) and other employee benefits. With the inception of 401(k) plans in the early 1980s, ERISA was extended to cover them as well, setting standards for eligibility, performance, investment selection, funding and vesting. Employers with these plans are required to hold the assets in a special custodial account, apart from corporate assets. That way, if the employer declares bankruptcy, the assets of the plan can't be touched by creditors.

IRAs are considered personal property and covered by state laws, said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter.

By default, these protections also cover workers. So, if you declare personal bankruptcy, creditors can't seize your defined-contribution money.

IRAs, on the other hand, aren't covered by ERISA because they aren't part of an employer-sponsored plan. As a result, IRAs are considered personal property, said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter.

"They are covered by personal property laws" which are written by states, Slott said.

Protection Trends

Over the past decade, states have been strengthening their bankruptcy and personal property laws so that IRAs can be shielded from creditors.

More and more states are excluding IRAs from the assets creditors can seize in the event of personal bankruptcy, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning. "The laws are changing," he said.

There are several reasons for this shift. The first is that IRAs are often the only available conduit for holding money from federally protected plans (such as 401(k)s) while workers are between jobs or waiting to be eligible to enroll in a new employer's plan. Consequently, there's a tacit acknowledgement that money held in these conduit IRAs will eventually be placed in a federally protected plan.

More states are excluding IRAs from the assets creditors can seize in the event of personal bankruptcy, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning.

Another realization: IRAs are commonly used to hold the majority of one's retirement monies. If a worker's retirement assets are wiped out in bankruptcy court, that worker may become another enrollee in state and federal welfare programs, said Keith Mong, attorney with Silverstein & Mullens, a division of Buchanan Ingersoll PC.

Still, IRAs are in the federal crosshairs. Earlier this year, Sen. Chuck Grassley, R-Iowa., proposed allowing creditors to force you to pay up from your IRA if you declare bankruptcy, if your balance is over a certain amount. A so-called "millionaire's cap" would protect IRA balances of $1 million for a debtor age 65, and decline to $250,000 for a debtor age 21. The intent is to try to satisfy creditors but allow workers to preserve some of their retirement savings. This language was quietly tacked onto the Bankruptcy Reform Act of 2000 that the House of Representatives approved last week. (See related story.) The Senate is expected to pass the bill, and President Clinton is expected to veto it.

With the emergence of two relatively new types of IRAs, Education and Roth, many states are again revising their laws to extend their protections, Mong said.

Strongest and Weakest Protections

Compiling a definitive list of IRA protections is like trying to hit a moving target. Slott should know. "I tried to do an article on them. By the time I got all the way through, half the states had changed their laws," he said.

Additional Resources In addition to the Investment Company Institute, Panel Publishers, a division of Aspen Publishers Inc. in Gaithersburg, Md., and the National Underwriter Co., in Cincinnati, Ohio, maintain state-by-state lists of IRA bankruptcy protections. The ICI list is free of charge while the other two charge a fee.

In March, the Investment Company Institute (ICI) released a snapshot of state bankruptcy protection laws that was current as of the end of 1999. But, even that survey is likely out of date. Check with a local attorney who specializes in bankruptcy, taxes or benefits for the laws that may apply to you, Slott said.

According to the ICI survey, some states offering the strongest bankruptcy protection include Connecticut, New Jersey, Ohio and Washington. As of the end of 1999, those states' bankruptcy laws protected IRAs, Roth IRAs, Education IRAs, SEP-IRAs and SIMPLE IRA plans.

But even these IRA-friendly states commonly waive the protection on money contributed to an IRA 90 to 120 days prior to declaring bankruptcy. The reason for this is that states don't want you to use an IRA as a tool to shelter money from creditors.

Likewise, money you roll into a 401(k) plan from a conduit IRA may not be protected if you move it too close to the time you declare bankruptcy. Check with a local attorney for the laws that may apply to you.

Related Reading If Your Company Declares Bankruptcy, What Happens to Your 401(k) Money? The Roth IRA: A Useful Estate-planning Tool

According to the ICI report, those states that appeared to offer some of the weakest protections and most ambiguous laws include: New Hampshire, District of Columbia, Iowa, Mississippi, Wyoming, New Mexico, South Dakota, Tennessee, Pennsylvania, Oklahoma, Nevada, Indiana, Hawaii, Georgia, and Alabama. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

IRAs May Be Vulnerable in Personal Bankruptcy

By Clifton Linton
Senior Writer, mPower

In This Story Time Travel Protection Trends Strongest and Weakest Protections

If you declare personal bankruptcy, retirement money in an IRA account could be seized by creditors. While federal laws universally prohibit creditors from touching retirement money in employer-sponsored plans, a patchwork of state laws controls individual retirement accounts.

The good news is that over the past few years, many state legislatures have been expanding protections.

minute: read this article at a glance.

Technical Terms Employee Retirement Income Security Act (ERISA) Roth IRA Conduit IRA

Most people think about bankruptcy in the same fashion they think about disease: It is something that happens to somebody else.

The truth is that financial tragedy could strike at any time and force anyone to seek bankruptcy protection. If that isn't bad enough, those money troubles could easily extend into retirement. The reason: Depending on the state in which you live, retirement assets held in IRA accounts could be vulnerable to creditors.

State laws, not federal, dictate IRA protections in the event of personal bankruptcy. And, as you can imagine, there are as many different bankruptcy treatments for your IRA money as there are states.

This means if you have a large (or even a modest but growing) IRA account balance, you need to figure out what protection your state offers. Because these protections often are buried deep within state laws, this may not be an easy task. But, resources are available to help you.

Let's take a look at how the laws developed, which states have historically offered some of the strongest protections and where to go to find out the rules in your state.

Time Travel

The best way to understand why IRAs are often susceptible to creditors (while employer-sponsored plans are not) is to travel back in time to 1974. That was the year Congress passed two laws: Section 408 of the IRS tax code, which created IRAs, and the Employee Retirement Income Security Act (ERISA).

ERISA was initially set up to protect defined-benefit programs (like pensions) and other employee benefits. With the inception of 401(k) plans in the early 1980s, ERISA was extended to cover them as well, setting standards for eligibility, performance, investment selection, funding and vesting. Employers with these plans are required to hold the assets in a special custodial account, apart from corporate assets. That way, if the employer declares bankruptcy, the assets of the plan can't be touched by creditors.

IRAs are considered personal property and covered by state laws, said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter.

By default, these protections also cover workers. So, if you declare personal bankruptcy, creditors can't seize your defined-contribution money.

IRAs, on the other hand, aren't covered by ERISA because they aren't part of an employer-sponsored plan. As a result, IRAs are considered personal property, said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter.

"They are covered by personal property laws" which are written by states, Slott said.

Protection Trends

Over the past decade, states have been strengthening their bankruptcy and personal property laws so that IRAs can be shielded from creditors.

More and more states are excluding IRAs from the assets creditors can seize in the event of personal bankruptcy, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning. "The laws are changing," he said.

There are several reasons for this shift. The first is that IRAs are often the only available conduit for holding money from federally protected plans (such as 401(k)s) while workers are between jobs or waiting to be eligible to enroll in a new employer's plan. Consequently, there's a tacit acknowledgement that money held in these conduit IRAs will eventually be placed in a federally protected plan.

More states are excluding IRAs from the assets creditors can seize in the event of personal bankruptcy, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning.

Another realization: IRAs are commonly used to hold the majority of one's retirement monies. If a worker's retirement assets are wiped out in bankruptcy court, that worker may become another enrollee in state and federal welfare programs, said Keith Mong, attorney with Silverstein & Mullens, a division of Buchanan Ingersoll PC.

Still, IRAs are in the federal crosshairs. Earlier this year, Sen. Chuck Grassley, R-Iowa., proposed allowing creditors to force you to pay up from your IRA if you declare bankruptcy, if your balance is over a certain amount. A so-called "millionaire's cap" would protect IRA balances of $1 million for a debtor age 65, and decline to $250,000 for a debtor age 21. The intent is to try to satisfy creditors but allow workers to preserve some of their retirement savings. This language was quietly tacked onto the Bankruptcy Reform Act of 2000 that the House of Representatives approved last week. (See related story.) The Senate is expected to pass the bill, and President Clinton is expected to veto it.

With the emergence of two relatively new types of IRAs, Education and Roth, many states are again revising their laws to extend their protections, Mong said.

Strongest and Weakest Protections

Compiling a definitive list of IRA protections is like trying to hit a moving target. Slott should know. "I tried to do an article on them. By the time I got all the way through, half the states had changed their laws," he said.

Additional Resources In addition to the Investment Company Institute, Panel Publishers, a division of Aspen Publishers Inc. in Gaithersburg, Md., and the National Underwriter Co., in Cincinnati, Ohio, maintain state-by-state lists of IRA bankruptcy protections. The ICI list is free of charge while the other two charge a fee.

In March, the Investment Company Institute (ICI) released a snapshot of state bankruptcy protection laws that was current as of the end of 1999. But, even that survey is likely out of date. Check with a local attorney who specializes in bankruptcy, taxes or benefits for the laws that may apply to you, Slott said.

According to the ICI survey, some states offering the strongest bankruptcy protection include Connecticut, New Jersey, Ohio and Washington. As of the end of 1999, those states' bankruptcy laws protected IRAs, Roth IRAs, Education IRAs, SEP-IRAs and SIMPLE IRA plans.

But even these IRA-friendly states commonly waive the protection on money contributed to an IRA 90 to 120 days prior to declaring bankruptcy. The reason for this is that states don't want you to use an IRA as a tool to shelter money from creditors.

Likewise, money you roll into a 401(k) plan from a conduit IRA may not be protected if you move it too close to the time you declare bankruptcy. Check with a local attorney for the laws that may apply to you.

Related Reading If Your Company Declares Bankruptcy, What Happens to Your 401(k) Money? The Roth IRA: A Useful Estate-planning Tool

According to the ICI report, those states that appeared to offer some of the weakest protections and most ambiguous laws include: New Hampshire, District of Columbia, Iowa, Mississippi, Wyoming, New Mexico, South Dakota, Tennessee, Pennsylvania, Oklahoma, Nevada, Indiana, Hawaii, Georgia, and Alabama. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.