When it comes to discussions around contributing money to retirement accounts, the main focus is usually on putting money away for a future retirement or for reducing current taxable income. Both of these are extremely valid points, but there is a third benefit that retirement accounts have for one’s financial health. That benefit is asset protection.
What is asset protection? It is planning your finances so that assets are protected against the claims of creditors and bankruptcy. It is best to develop an asset protection strategy ahead of time, as it is often too late to protect assets from creditors after a claim or liability occurs.
One of the easiest ways to protect assets from creditors is by contributing to employer-sponsored and individual retirement accounts. The amount of protection varies depending on the type of account, but that is broken down in more detail here. The asset protection features of retirement accounts make it that much more attractive to invest in these accounts before starting to invest in a taxable brokerage account that does not receive asset protection.
401(k) and Other Employer-Sponsored Retirement Accounts
The greatest amount of protection lies within 401(k) and other employer-sponsored retirement accounts, like the 403(b) or Thrift Savings Plan (TSP). These accounts receive federal (ERISA) protection from creditors on an unlimited basis. Although these accounts are protected, there are two instances where the protective shield can be broken - by the IRS and by an ex-spouse due to divorce.
What does this mean? If someone with $5 million dollars in their 401(k) files for bankruptcy, they are not required to give up that asset. For individuals who own their own business or work in a high-lawsuit field, a defined contribution retirement plan is a great benefit for asset protection purposes.
IRA and Roth IRA
IRAs, including employer-sponsored IRAs like SEP and SIMPLE IRAs, do not receive the ERISA protection that 401(k)’s do. These accounts will be subject to the asset protection levels in the state one lives in. For example, Tennessee fully protects IRA and Roth IRA assets like 401(k)’s are protected. However, Maine only protects up to $15,000 of IRA and Roth IRA assets.
Suffice it to say, each state varies greatly in asset protection benefits for IRA assets. This makes it vitally important to understand the rules in the state you live in.
The least amount of protection is given to the Inherited IRA, or an IRA account of an owner that passes away and the assets are rolled into an Inherited IRA for the beneficiary. These accounts are fully available to bankruptcy proceedings and to general creditors.
Although an Inherited IRA does not receive asset protection, it is still a great account as it allows for long-term tax-deferred growth of retirement assets. For younger beneficiaries, only a small percentage of the account is required to be withdrawn each year as a required minimum distribution.
Lastly, even if you live in a state that does not fully protect IRA assets, all is not lost. What happens when you rollover your employer-sponsored 401(k) that receives federal asset protection into a Rollover IRA? The assets still receive full bankruptcy protection, but will now be subject to state law for non-bankruptcy creditor protections. However, a Rollover IRA with assets from a SEP or SIMPLE IRA may only receive up to $1 million of bankruptcy protection.
Having said all of this, most states do provide a great deal of asset protection to IRAs either equal-to or similar-to the ERISA federal protections. As with anything, financial planning is very specific to the individual, including the state you live in. If you live in a state that does not provide asset protection to IRAs, you will need to determine how important that benefit is before rolling over your assets from a 401(k) into an IRA.
The information provided here should not be considered legal advice. Please consult your attorney before implementing any legal or asset protection strategies.