5 Retirement Account Creditor Protection Myths … And What Facts REALLY Are

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

The creditor protection rules that apply to retirement accounts are complex and frequently misunderstood. In an effort to correct some of the most frequently misunderstood concepts and provide some clarity in these seemingly murky waters, below we explore 5 Retirement Account Creditor Protection Myths and then give you the real facts behind them.

Myth #1 – Retirement Money is Universally Protected from Creditors
Fact: While much of the money, and indeed, perhaps all the money you have in your retirement accounts is likely shielded from your creditors, you shouldn’t automatically assume that to be the case. Retirement funds receive varying degrees of creditor protection depending on a number of factors, including the type of retirement account the funds are in, such as a 401(k) vs. an IRA, and what state you happen to live in.

Myth #2 – Plan Money is Always Creditor Protected
Fact: Some retirement funds held in employer plans receive exceptionally strong creditor protection under the federal law known as ERISA (Employee Retirement Income Security Act). In order to qualify for this protection, however, the retirement funds have to be held in an ERISA-covered plan account. IRAs, including IRA-based plans like SEP and SIMPLE IRAs, do not receive ERISA protection. On the other hand, defined benefit (pension) plans and 401(k) plans typically do qualify for such protection. There are some exceptions, however, such as the creditor protection of solo 401(k)s. Solo 401(k)s are 401(k) plans that cover a business owner with no employees, or a business owner with no employees and their spouse. Instead of creditor protection under ERISA, retirement funds in these accounts receive whatever protection is afforded to them under the applicable state law.

Myth #3 – General Creditor Protection and Bankruptcy Protection are the Same
Fact: While filing for bankruptcy can help resolve some creditor issues, not all creditor issues warrant or result in filing for bankruptcy. For instance, if you had $1 million dollars in an attachable account (an account available to creditors) and were issued a judgment for $300,000, there wouldn’t be much point to filing for bankruptcy, since you’d clearly still be solvent. On the other hand, if you were issued a similar judgment of $1.5 million, you’d most likely be insolvent and filing for bankruptcy would be worth considering. So why is this so important? Simply because there are different rules that govern the protection of retirement accounts when bankruptcy is filed as opposed to similar situations when bankruptcy is not filed. If you are filing for bankruptcy, there’s a strong – though not absolute – possibility that all of your retirement funds will be protected, regardless of the type of plan they’re currently in, thanks to the Bankruptcy Abuse Prevention and Consumer Protection Act.

Myth #4 – Retirement Account Beneficiaries Have the Same Levels of Protection as Owners
Fact: This one was up for debate for a while, but was finally settled beyond any doubt by the U.S. Supreme Court earlier this summer. In a unanimous, 9-0 decision, the Court ruled that inherited IRAs are not protected in bankruptcy in the same manner that an individual’s own IRAs are. For more information on the case, the Supreme Court’s inherited IRA decision and what planning strategies you may wish to consider now, click here.

Myth # 5 – Plan Money Retains its Creditor Protection When it’s Rolled Over to an IRA
Fact: If money in an ERISA-covered plan account is rolled over to an IRA, the ERISA creditor protection no longer applies. Instead, the creditor protection afforded to IRAs under state law will apply. This rule is often confused with the bankruptcy protection plan funds received when they are rolled over, which is generally retained. In some states, where IRA creditor protection laws are strong, this will have little impact on the safety of your retirement savings. In other states, however, where state-provided IRA creditor protection is not as strong, greater attention to the potential loss of protection should be considered.