What is IRA bankruptcy protection? Here’s everything investors need to know to protect their assets in the event of bankruptcy.
In this article:
- Bankruptcy Abuse Prevention and Consumer Protection Act
- Exempted Retirement Accounts
- Fully-Protected Retirement Accounts
- Traditional IRAs and Roth IRAs
- Rollover IRAs
- Inherited IRAs
- Withdrawn Retirement Benefits
What Is IRA Bankruptcy Protection? | How to Protect Assets While in Bankruptcy
Bankruptcy Abuse Prevention and Consumer Protection Act
What is IRA bankruptcy protection? In the event of bankruptcy, all types of Individual Retirement Accounts (IRAs) the federal tax code recognizes will have a significant level of protection against creditors.
In 2005, former President George W. Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The law protects IRAs, with each type of IRA having their own protection guidelines.
Federal bankruptcy laws have always protected pensions, 401(k) plans, and other employer-sponsored, qualified retirement plans. With the enactment of the BAPCPA, IRAs also came under federal protection.
Among a wide variety of bankruptcy reforms, which also includes heightened requirements for filing Chapter 7 bankruptcy, BAPCPA also introduced the first clear federal bankruptcy protections for assets inside IRAs.
Prior to the BAPCPA, IRA protections were only defined at the state level, if at all. After its enactment, the laws provided bankruptcy protection for assets inside IRAs to citizens in all states.
Exempted Retirement Accounts
One can use bankruptcy exemptions to avoid losing everything they own when filing for bankruptcy.
Bankruptcy exemptions can protect property one needs to live and work. This can include equity in a:
- Household belongings
With the BAPCPA, almost all ERISA-qualified retirement accounts and pension plan funds are exempt from creditors.
ERISA Definition: ERISA, or the 1974 Employee Retirement Income Security Act, is a law that provides protection for individuals in a majority of voluntarily-established retirement and health plans. It sets minimum standards for these plans in the private industry.
However, some exceptions remain:
- Chapter 7 bankruptcy – In this chapter, even if investors give up their property, their retirement funds remain safe because they’re protected by Congress and possibly by another exemption (each state has its own set of exemptions).
- Chapter 13 bankruptcy – Because one’s retirement accounts are exempt, their balance won’t affect how much needs to be repaid to creditors in the three- to five-year Chapter 13 repayment plan.
In this particular context, “retirement account” means the funds in the actual account. How those funds are treated after they’re withdrawn is different.
Fully-Protected Retirement Accounts
Answering “What is IRA bankruptcy protection?” starts with knowing which accounts are fully protected.
With a few limitations, the exemption amounts are unlimited. As such, the law protects the retirement account’s whole amount.
ERISA-qualified pension plans, such as the ones listed below, are some of the plans that are subject to this exemption.
- IRAs (Roth, SEP, and SIMPLE, with certain limitations)
- Defined-benefit plans
- Profit-sharing plans
- Money purchase plans
If they’re not an ERISA-qualified plan, other accounts like general savings accounts, stock option plans, and investment accounts won’t be protected, and unfortunately, many are not.
Additionally, few states provide exemptions that protect bank and investment account funds. Even when they do, the coverage is minimal (with $300 being the common amount).
One will lose unprotected funds both in Chapter 7 and Chapter 13 bankruptcy. The money will be used to pay creditors.
Traditional IRAs and Roth IRAs
In its first year, it provided protection for as much as $1 million in assets held in either a Traditional IRA or a Roth IRA.
The law sets down a regular adjustment for inflation based on the Consumer Price Index for All Urban Consumers of the Department of Labor. This helps maintain the protection’s real value over time.
Adjustments Made in the BAPCPA
The first adjustment was made on April 1, 2007. It has been calculated and passed every three years since then.
As of April 1, 2019, the law limits the amount that bankruptcy courts can’t use to repay creditors to $1,362,800 per individual for IRAs. The bankruptcy court can use anything in excess of that amount to pay back creditors.
The April 1, 2019 adjustment was the most recent adjustment that occurred. The limit will adjust to inflation again in the year 2022.
However, the law further adds that bankruptcy courts also have the power to grant additional protection if necessary and should the judge decide to extend it. However, if the IRS has a tax lien against the debtor, the law may not protect Roth IRAs.
Take note that this exemption applies to a combination of all of a person’s retirement plans. One can’t exempt $1,362,800 for each plan.
In the context of the BAPCPA, a rollover IRA is either a Traditional IRA or a Roth IRA originally funded through a transfer from a qualified retirement plan. These include Standard 401(k) plans, certain profit-sharing plans, or traditional pension plans.
During bankruptcy, the BAPCPA fully shields a properly executed rollover IRA that originates from a qualified retirement plan.
Once the rollover of assets is complete, one must keep in mind that apart from the source of the assets, a rollover IRA, in essence, is no different from any other Traditional or Roth IRA.
To ensure its full protection, one should create a separate IRA account for the rollover assets. This account should be separate from all other existing Traditional IRA or Roth IRA accounts.
While the law doesn’t specifically require an investor to maintain separate accounts, it helps to avoid potential issues during bankruptcy proceedings.
Having separate accounts makes it easy to document the origin of assets. Asset pools are easy to track as well, especially when securing all available bankruptcy protections.
Federal bankruptcy law doesn’t cover the protection of inherited IRAs.
A 2014 U.S. Supreme Court case said that inherited IRAs, by definition, don’t fall under “retirement funds” that a bankruptcy protects. The case explained inherited IRAs aren’t really funds someone has set aside for retirement.
The Court gave further reasons, such as the fact that beneficiaries of a Roth IRA don’t have to add any money. Though beneficiaries may be years from retirement, it’s necessary for them to take distributions regardless of their age.
Furthermore, beneficiaries can withdraw some or all of it at any time without a penalty.
While no federal bankruptcy protection exists for inherited IRAs, one might find that protection at the state level. A number of states including North and South Carolina, Texas, Florida, Missouri, Arizona, Ohio, and Alaska all have their own set of bankruptcy protection measures for inherited IRAs.
Do note that if the beneficiary is a spouse, he or she may secure federal protection. Should the spouse roll over the account to his or her own Roth IRA, bankruptcy courts will most likely treat those funds as if the spouse funded the account.
No cases or rulings have been made on whether the spouse will enjoy the same benefits as the owner.
Withdrawn Retirement Benefits
The discussion of “What is IRA bankruptcy protection?” should not end in the accounts themselves. One should also take into account retirement benefits paid as income.
Although the funds in one’s retirement account are mostly exempt from creditors, retirement benefits paid as income are not.
In Chapter 7 bankruptcy, the court considers funds one receives from a pension or retirement account as income monthly payment. This income will be included in the Chapter 7 means test qualification.
In this case, bankruptcy court doesn’t have the power to take retirement benefits that are necessary for one’s support. They may, however, take amounts that go beyond what that individual needs for support and use it to repay creditors.
In Chapter 13 bankruptcy, on the other hand, retirement income helps determine what portion of unsecured debts one has to repay in his or her Chapter 13 repayment plan.
Finding out exactly what will happen to one’s retirement funds in bankruptcy is of great significance. In many cases, it is best to speak with a qualified bankruptcy lawyer to know exactly what IRA bankruptcy protection is and to receive proper guidance on it.
Do you have other questions about IRA bankruptcy protection? Ask us in the comments section below!
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