25 Sep IRAs and bankruptcy: Are they protected?
Many small business owners have a significant amount of their wealth in individual retirement accounts (IRAs). Are those assets protected in the owner must file bankruptcy if the business fails or is in trouble?
For the most part, yes.
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 shields traditional IRAs, Roth IRAs and most other nonqualified tax-exempt retirement accounts from bankruptcy creditors, up to a $1 million limit (which can be increased at the bankruptcy court’s discretion). Retirement funds are protected regardless of the debtor’s needs or the requirements of state law.
The $1 million limit doesn’t apply to assets rolled into an IRA from a qualified plan. These funds, as well as their earnings, enjoy unlimited protection. To keep track of IRA assets that are exempt from the $1 million cap, consider rolling qualified plan distributions into separate IRAs.
Supreme Court rules, twice
In its landmark 1992 decision in Patterson v. Shumate, the U.S. Supreme Court addressed bankruptcy protection for qualified retirement plans, such as employer-sponsored pension, profit-sharing and 401(k) plans. The court held that the Employee Retirement Income Security Act of 1974 (ERISA) protects these assets from creditors both within bankruptcy and, generally, outside of it as well.
But ERISA doesn’t apply to IRAs unless they’re part of an employer plan, so the Court’s decision didn’t apply to them. Although IRA assets usually receive some protection under state law, these laws vary widely from state to state. Often, this protection is limited to a modest dollar amount or to an amount “reasonably necessary” for the debtor’s support.
In 2005, the Supreme Court’s decision in Rousey v. Jacoway expanded federal bankruptcy protection for IRAs. But the decision didn’t afford IRAs the same protection enjoyed by qualified plans.
In Patterson, the Court ruled that qualified plans are excluded from the “bankruptcy estate,” endowing them with nearly absolute protection against creditors’ claims. But in Rousey, the Court merely held that IRA savings fall within a federal bankruptcy exemption for “retirement assets.” This exemption is limited to assets that are reasonably necessary to support the debtor and his or her dependents. What’s more, the exemption doesn’t apply at all in states that have opted out of the federal exemption scheme.
Protection isn’t unlimited
IRA protection is limited, especially when it comes to creditors’ claims outside of bankruptcy. If IRA assets are eventually threatened, however, bankruptcy offers a real option for protecting them.