Asset Protection - Part 1

May 4, 2012, 3:22 PM

How safe are the assets in your retirement account? Imagine the following scenarios:

  1. You are in a car accident that results in a serious injury. Your insurance coverage is insufficient, leaving you with personal liability in the amount of $250,000. You have $200,000 in a 401(k) account, $50,000 in an IRA, and $25,000 in net assets outside these accounts. Can the injured party collect the judgment by attaching the assets in your 401(k) plan? How about your IRA?
  2. After losing your job, you find yourself over $50,000 in debt and begin to consider filing for personal bankruptcy protection. Your most significant asset is $25,000 in an IRA that originated as a rollover from your former employers profit sharing plan. Are you required to count the assets in your IRA when determining whether you can file bankruptcy? Will you be required to apply the IRA assets to pay off part of your debt?
  3. You recently switched jobs and have $75,000 in an account under your former employers 403(b) plan. You are not thrilled with the investment options available under the 403(b) plan and would like to roll the account over into an IRA; however, you are concerned about a pending legal judgment and want to make sure that these assets will be protected against your creditors to the maximum extent possible. Should you keep the assets in the 403(b) plan or roll them into an IRA?

Asset protection is an important retirement planning consideration that is often overlooked. When considering where to place your retirement savings, keep in mind that different savings vehicles may leave your assets more exposed to the claims of creditors than others. This article outlines the basic asset protection rules applicable to ERISA plans, IRAs, nonqualified deferred compensation plans, and other common retirement savings vehicles.

  1. ERISA Plans

Assets held in a qualified retirement plan sponsored by an employer or former employer (including 401(k) plans, profit-sharing plans, defined benefit pension plans, and ESOPs, among other types of plans) are covered by the Employee Retirement Income Security Act of 1974 (ERISA), a federal law that mandates a strong level of protection for retirement savings. ERISA also applies to certain 403(b) plans offered by non-profit or governmental employers. As a general rule, ERISA plans offer the most solid protection that is available under the law.

ERISA (as well as the parallel sections of the U.S. Tax Code) protects plan assets in several ways. First, ERISA requires that assets held in an employers retirement plan must be used for the exclusive purpose of providing benefits to plan participants and beneficiaries. ERISA also contains an anti-alienation rule prohibiting a plan from assigning plan benefits to any person other than the plan participant or beneficiary, and also from allowing any attachment, garnishment, or other forms of legal process against plan assets. What this means as a practical matter is that the plan is prohibited from paying the amount credited to a participants account to anyone but the participant. If a creditor contacted the plan administrator seeking to collect on a personal debt, the plan administrator would be required by law (and by the terms of the plan) to deny the claim.

As an additional layer of protection, ERISA plans are protected against claims under competing state laws. ERISA contains a broad preemption clause providing that ERISA supersedes any state law to the extent that the law relates to an employee benefit plan, meaning that ERISAs protections (such as the anti-alienation rule) can be used to defend against collection actions in any U.S. jurisdiction.

The major exception to the exclusive benefit and anti-alienation rules is Qualified Domestic Relations Orders (QDROs), which pertain to the collection of court-ordered alimony, child support, or property division payments. If a plan participant is ordered to use assets from an ERISA plan in connection with a QDRO, the plan administrator can divert the assets in the plan account as required by the order without first obtaining the participants consent.

With respect to bankruptcy, assets held in an ERISA plan are treated as exempt for purposes of federal bankruptcy law (but may not be treated as exempt in all states, so make sure to do your homework to understand the bankruptcy laws applicable to the state where you reside or file for bankruptcy protection). This means that assets held in an ERISA plan are not counted as assets that must be used to pay off creditors under the federal bankruptcy rules, and the debtor is thus allowed to retain these assets after going through bankruptcy. Under Virginia law, assets held in an ERISA plan are also treated as fully exempt to the same extent as provided under Federal law. (Prior to 2007, however, Virginia law only exempted ERISA plan assets up to a certain level a reminder that state bankruptcy laws can differ from federal laws in important ways, and can also be subject to change.)

II. Individual Retirement Accounts (IRAs)

Assets held in an IRA or Roth IRA are not covered by ERISA, and thus do not qualify for the heightened protection of the exclusive benefit rule, anti-alienation rule, or ERISA preemption. This result applies regardless of whether the assets originated as contributions to the IRA or as a rollover from another IRA or ERISA plan. One implication of a decision to roll assets out of an ERISA plan and into an IRA is thus that the rollover may leave the assets more exposed to the claims of creditors than otherwise would have been the case.

Assets held in an IRA are generally subject to state law asset protection rules, which can vary widely from state to state. Many states, including Virginia, exempt assets held in an IRA from the claims of creditors to the same extent as assets held in an ERISA plan. (Prior to 2007, IRA assets were not treated as exempt under Virginia law if the debtor also held assets in an ERISA plan.) However, this is not universally the case. In some states, IRA assets are only partially exempt from the claims of creditors, and in others IRA assets are not exempt at all.

Federal bankruptcy law exempts assets held in an IRA to the same extent as assets held in an ERISA plan. Residents of a state that does not fully exempt IRA assets for purposes of state bankruptcy law may thus prefer to apply federal exemptions if allowed.

The major point to consider when deciding whether or not to roll assets from an ERISA plan into an IRA is that IRA assets will not be protected equally in all locations. If you currently reside in a state, like Virginia, that treats IRAs the same as ERISA plans for asset protection purposes, you may feel comfortable making the rollover. However, if you ever relocate in the future, you may move into a jurisdiction that leaves the IRA assets more exposed to creditors. General information about the bankruptcy and asset protection rules applicable in different states can be found online at sites such as Legal Consumer.com (http://www.legalconsumer.com/), but it is always best to seek the advice of counsel licensed to practice law in the state in question. --Shad C. Fagerland