RETIREMENT accounts have become many Americans’ most valuable assets. That means it is vital that you have the ability to protect them from creditors, such as people who have won lawsuits against you.
In general, the asset/creditor protection strategies available to you depend on the type of retirement account you have (i.e. Traditional IRA, Roth IRA, or 401(k) qualified plan, etc.), your state residency, and whether the assets are yours or have been inherited.
Federal Protection for 401(k) Plan Qualified Plan for Bankruptcy
Effective for bankruptcies filed after October 17, 2005, the following rules give protection to a debtor’s retirement funds in bankruptcy by way of exempting them from the bankruptcy estate. The general exemption found in section 522 of the Bankruptcy Code, 11 U.S.C. §522, provides an unlimited exemption for retirement assets exempt from taxation for Section 401(a) (tax qualified retirement plans—pensions, profit-sharing and section 401(k) plans). Thus, ERISA qualified plans as well as Solo 401(k) plans are afforded full bankruptcy exemption. What this means is that if a participant of a 401(k) Plan declares bankruptcy, his or her 401(k) plan assets will be exempt from the bankruptcy proceeding and could not be attached by the bankruptcy’s estates creditors.
Federal Protection for 401(k) Plan Qualified Plan Funds Outside of Bankruptcy
In the case of a debtor who is not under the jurisdiction of the federal bankruptcy court but rather has become involved in a state law insolvency, enforcement, or garnishment proceeding, the 2005 Bankruptcy Act is inapplicable and the ERISA rules and state laws would govern.
Title I of ERISA requires that a pension plan provide that benefits under the plan may not be assigned or alienated; i.e., the plan must provide a contractual “anti‑alienation” clause. For the anti-alienation clause to be effective, the underlying plan must constitute a “pension plan” under ERISA. Such a plan is any “plan, fund or program which…provides retirement income to employees.” ERISA §3(2)(A).. Therefore, a plan that does not benefit any common-law employee is not an ERISA pension plan. As a result, a Solo 401(k) Plan is not treated as an ERISA Plan.
In addition to the ERISA protection, the Internal Revenue Code Section 401(a)(13(A) provides that “[a] trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that benefits provided under the plan may not be assigned or alienated. Thus, a retirement plan will not attain qualified status unless it precludes both voluntary and involuntary assignments.
Note – neither ERISA nor Code protections apply to assets held under individual retirement arrangements, simplified employee pension plans, government plans, or most church plans.
Furthermore, ERISA section 514(a) provides that ERISA supersedes state laws insofar as such laws relate to employee benefit plans. The ERISA anti-alienation and preemption provisions combine to make state attachment and garnishment laws inapplicable to an individual’s benefits under an ERISA-covered employee benefit plan.
There are a number of exceptions to ERISA’s and the Code’s anti‑alienation provisions:
1. Qualified domestic relations orders (“QDROs”), as defined in Internal Revenue Code Section 414(p), may be exempted (Internal Revenue Code §401(a)(13)(B); ERISA §206(d)(3)). This means that retirement plan assets are a marital asset subject to division in divorce and attachment for child support.
2. Up to 10 percent of any benefit in pay status may be voluntarily and revocably assigned or alienated (Internal Revenue Code §401(a)(13)(A); Treas. Reg. §1.401(a)-13(d)(1); ERISA §206(d)(2)).
3. A participant may direct the plan to pay a benefit to a third party if the direction is revocable and the third party files acknowledgment of lack of enforceability (Treas. Reg. §1.401(a)-13(e)).
4. Federal tax levies and judgments are exempted. The Treasury Regulations under Code section 401(a)(13) provide that plan benefits are subject to attachment by the IRS in common law and community property states.
In addition to the statutory exceptions noted above, several court decisions have held that an individual’s retirement plan benefits may be subject to attachment for federal criminal penalties or restitution arising from a crime
Solo 401(k) Plans
A debtor’s plan benefits under a pension, profit-sharing, or section 401(k) plan are generally safe from creditor claims both inside and outside of bankruptcy due to ERISA and the Code’s broad anti-alienation protections. However, case law and Department of Labor Regulations have held that such a plan that benefits only an owner (and/or an owner’s spouse) are not ERISA plans, thus voiding the anti-alienation protections generally afforded to ERISA plans. Thus, state law will govern the protection afforded to Solo 401(k) Plans outside the bankruptcy context.
State Law Protection of Solo 401(k) Plan Assets Outside of Bankruptcy
Because case law and Department of Labor Regulations have held that such a plan that benefits only an owner (and/or an owner’s spouse) are not ERISA plans, thus voiding the anti-alienation protections generally afforded to ERISA plans, state law will govern the protection afforded to Solo 401(k) Plans outside the bankruptcy context.
Click here for a table that will provide a summary of state protection afforded to Solo 401(k) Plans from creditors outside of the bankruptcy context.
Asset Protection Planning
The different federal and state creditor protection afforded to 401(k) qualified plans and IRS inside or outside the bankruptcy context presents a number of important asset protection planning opportunities.
If, for example, you have left an employer where you had a qualified plan, rolling over assets from a qualified plan, like a 401(k), into an IRA may have asset protection implications. For example, if you live in or are moving to a state where IRAs are not protected from creditors or have in excess of $1million dollars in plan assets and are contemplating bankruptcy, you would likely be better off leaving the assets in the company qualified plan.
Note – If you plan to leave at least some of your IRA to your family, other than your spouse, the assets may not be protected from your beneficiaries’ creditors, depending on where the beneficiaries live. IRA assets left to a spouse would likely receive creditor protection if the IRA is re-titled in the name of the spouse. However, you will likely be able to protect your IRA assets that you plan on leaving to your family, other than your spouse, by leaving an I.R.A. to a trust. To do that, you must name the trust on the IRA custodian Designation of Beneficiary Form on file.
The Solo 401(k) Asset & Creditor Protection Solution
By having and maintaining a Solo 401(k) Plan, the people to whom you owe money – as a result of normal debt, bankruptcy or a civil court judgment – will likely not be able to reach your Solo 401(k) assets to satisfy the debt. However, Solo 401(k) Plan assets are not federally protected from divorce settlements or federal tax liens. As illustrated above, most states will afford Solo 401(k) Plans full protection from creditors outside of the bankruptcy context.
Please contact one of our Tax Experts at 800-472-0646 for more information.