Is my safe money safe? Pt. 4

By Dick Duff

RWD Enterprises

In Pt. 3 of this series, we looked at how life insurance cash values and death benefits are protected from creditors, lawsuits and in bankruptcy. The objective is to safeguard funds (a) in a policy, (b) in a carrier's general fund, (c) at point of release, and (d) after they reach a policy owner or beneficiary. In this column, we'll review how the system protects "tax-exempt" retirement plan assets. Our ongoing goal is to make sense out of a bunch of confusing laws.

First, three housekeeping comments:
    1. Life insurance (and annuities) are protected under state laws, usually where a policy owner or beneficiary lives. Tax-exempt retirement plans are protected under a combination of (a) The Bankruptcy Abuse Prevention Consumer Protection Act of 2005 (BAPA), (b) The Employee Retirement Income Security Act of 1974 (ERISA) and (c) various state laws.

    2. Non-tax-qualified annuities have less protection than money in life insurance policies. It seems that family security (mostly from insurance) trumps retirement income (mostly from annuities) in the eyes of lawmakers and the courts. In general, one-third of the states fully protect annuity cash values and death proceeds; about one-third provide partial shelter; and one-third offer no safeguarding. If your state favors life insurance, this should influence recommendations of single-premium life policies over tax-deferred annuities.

    3. I'll break down "tax-exempt retirement funds" into (a) QPs (all qualified retirement plan accounts -- employer 401(k)s, pensions and profit plans, Keoghs, deferred compensation programs for government workers, 403(b) annuities, SEP and Simple IRAs -- most every retirement plan in common parlance), and (b) IRAs, both personal traditional and Roth accounts. Life insurance and non-qualified commercial annuities aren't included in this definition.
Below, I've asked three questions about QPs, then three questions about IRAs (and provided answers):

Question 1: Is my QP protected if I go bankrupt?

Answer: Yes... mostly. As a tax-exempt retirement plan under BAPA, it is fully sheltered except for qualified domestic relation order (QDRO) claims and certain tax debts.

Question 2: Is my QP protected from my general creditors and lawsuits and short of bankruptcy?

Answer: Yes, for the most part. Here, it's the Employee Retirement Income Security Act (ERISA) of 1974 that does the safeguarding. QPs -- except for SEPs, government and church plans, and seemingly owner-only corporate plans and Keoghs -- are sheltered from general creditors and lawsuits. QDRO obligations, federal tax debts, and certain criminal and civil tax judgments and penalties are not shielded.

Question 3: Are my QP required minimum distributions (RMDs) and other withdrawals protected from my general creditors, lawsuits and in bankruptcy?

Answer: BAPA (in bankruptcy) and ERISA (general creditors and lawsuits) protect assets held in the plan itself. So, when money comes out of the QP, it could be fair game for some clever claimant. In fact, there are a number of cases (usually involving prison inmates) where pension incomes have been attached to or garnisheed grom someone's checking account.

There is some hope for debtors. For instance, Florida protects pension incomes received within three months preceding "execution, attachment or garnishment proceedings." And, Illinois case law exempts retirement plan distributions when (a) deposited to a checking or savings-and-loan account, and (b) this money is for the support of self and family. *Note: If these funds are reinvested and not used for support, the creditor protection is usually lost.

Be aware: Since states mostly control what happens when funds leave a QP, you (and an attorney) must navigate the history of statutes and litigation in your state for the answers. If there isn't much available information on this, your best bet is to review similar laws in other states. This isn't an easy task. Let your thirst for information guide you to the level of knowledge you'll need.

Question 4: Is my IRA protected if I go bankrupt?

Answer: Yes, for the most part. Under BAPA, IRAs are lumped with QPs as tax-exempt retirement funds. It would have been nice if Congress had stopped right there. But it didn't; rather, it limits tax-deductible IRAs to $1 million of shelter, adjusted for inflation -- up to $1,095,000 in 2007. (Rollovers from QPs to IRAs have unlimited protection.)

Question 5: Is my IRA protected from my general creditors and lawsuits and short of bankruptcy?

Answer: Yes, maybe. As noted, ERISA (not BAPA) protects your QP outside of bankruptcy. But, you'll have to look to your state law regarding IRAs.

Presently, state protective IRA statutes are not uniform. There are laws that (a) fully protect the account, (b) limit shelter to support of self and dependents, (c) cap the amount safeguarded, (d) shelter only contributions to the account within a 90- to 120-day period before financial stress, and (e) differentiate between type of personal IRA -- traditional or Roth. In fact, you could say that in 2008, 41 states give protection for traditional accounts, while only 36 states exempt Roths.

Question 6: Are my IRA required minimum distributions (RMDs) and other withdrawals protected from my general creditors, lawsuits and in bankruptcy?

Answer: BAPA (in bankruptcy) and state laws (general creditors and lawsuits) protect funds in the IRA itself. It's state law that controls distributions from an account and most states have little to say on this subject (or limit protection to distributions used for support). In one case, an IRA was pledged for a loan and left unshielded because that was a deemed distribution to the account owner. Indeed, most commentators caution that those in financial stress shouldn't take money out of their IRA.

In summary, it's not easy to get a full grasp on how tax-exempt retirement assets are protected from creditors. Memorize the following:
  • In bankruptcy, BAPA protects funds within QPs and IRAs.

  • Outside bankruptcy, ERISA protects funds in most QPs, and state laws control what happens to IRAs.

  • State laws will tell us if QP and IRA distributions are sheltered.
In next month's column, I will deal with a dozen or so tax and asset protection strategies for beneficiaries of QPs and IRAs. If asset protection is the goal (as long as possible), it's best to consider beneficiaries as "partners" in the plan. We'll do this and more!

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