Is your IRA safe from creditors?

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Explore:  Asset Management IRA

If a substantial portion of your wealth is in one or more IRAs, protecting the assets in those accounts is critical to your estate plan. IRAs provide significant benefits, including tax-deferred wealth accumulation during your life and, with proper planning, during the lives of your beneficiaries.

Asset protection during your life

The extent to which IRAs are protected against creditors’ claims first depends on whether the claims are brought in a bankruptcy context. In bankruptcy, federal law controls.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, IRAs are exempt from creditors in bankruptcy up to $1 million (in contrast to qualified retirement plans, which are fully exempt). The $1 million limit doesn’t apply, however, to amounts rolled over from a qualified plan, including earnings on those amounts. So, for example, if you roll over $2 million from a 401(k) plan into an IRA, the full $2 million, plus all future earnings, is exempt.

To ensure that rollover IRAs are fully protected, maintain documentation of the rollover transaction. It’s also a good idea to include “rollover” in the account name and to segregate rollover IRAs from other IRAs.

Outside of bankruptcy, the answer depends on state law. Most states offer some level of asset protection for IRAs, a majority offering full protection. Some states exempt only a portion of an IRA, such as the amount reasonably necessary for the owner’s support. Even in states that offer a complete exemption, the IRS can reach IRA assets to satisfy a federal tax lien.

Asset protection for your heirs

If you name your spouse as beneficiary of your IRA, he or she can roll the funds over into his or her own IRA after you die. Although nonspousal beneficiaries can take a lump sum distribution or distribute the funds over five years, typically they choose to hold the funds in an “inherited IRA,” which allows them to maximize tax deferral by spreading distributions over their life expectancies.

Unfortunately, there’s some uncertainty about whether the asset protection available to IRAs extends to inherited IRAs. In bankruptcy, the courts are divided on this issue. Outside of bankruptcy, some states expressly apply their exemptions to inherited IRAs, but most simply exempt “IRAs” without specifying how inherited IRAs are treated. In those states, courts have gone both ways, some finding that inherited IRAs are exempt and some finding that they aren’t.

If you’re concerned about creditor protection for an heir who lives in (or might move to) a state with unfavorable or uncertain asset protection laws for inherited IRAs, consider alternative strategies. For example, you might set up a spendthrift or asset protection trust for the heir and name the trust as beneficiary of your IRA. If the trust is designed properly, it will allow distributions to be spread out over your heir’s life expectancy while protecting the trust assets against creditor claims.

Act now

If you have large balances in one or more IRAs, consult your estate planning advisors to discuss strategies for protecting these funds from creditors and preserving as much of the wealth as possible for future generations. If you need to set up trusts or change beneficiary designations, the sooner you do so, the better.