Most people do not anticipate a situation in which a creditor will come after their assets, but these situations are more common than you might think. For example, say your teenager is involved in a car accident and the injured party files a civil suit – your assets could be vulnerable. Likewise, if you get divorced or must file for bankruptcy, your assets can be attached or garnished.
If you would like to protect your portfolio against the possibility of creditors getting access to your assets – now or after you pass assets on to your heirs – it’s a good idea to understand what accounts are the best vehicles to protect your assets.
Up to $1 million in aggregate of all Individual Retirement Accounts’ assets are protected from creditors if you file for bankruptcy. Moreover, a bankruptcy court has the discretion to increase this cap in the “interest of justice.” Outside of a bankruptcy situation, whether or not your IRA will be protected from creditors is largely dependent on state law. The majority of states shield all assets of a traditional IRA from creditors; slightly fewer (but still most) states offer the same protection for a Roth IRA.
Employer-sponsored plans, such as the 401(k), 403(b), 457(b), SEP IRA and SIMPLE IRA, enjoy unlimited protection under the Employee Retirement Income Security Act of 1974 (ERISA). If you roll over assets from an employer-sponsored plan, they will then be subject to the $1 million limited protection given an IRA in a bankruptcy proceeding, and be subject to state law outside of bankruptcy.
Limited Liability Protection
You can also structure your IRA to wholly own an LLC for the same reason individuals use LLCs in their personal investment and business activities – to limit personal liability. Using a Self-Directed IRA LLC to make investments offers you greater asset and creditor protection than making investments personally. For example, say you purchase rental property under your IRA/LLC and a renter then files a lawsuit as a result of being injured on the property. In this case, only the assets owned by the IRA/LLC are at risk; the lawsuit may not go after your other personal assets.
You might be able to protect IRA assets that you plan to leave to your family (other than your spouse) by naming a trust as your designated IRA beneficiary because a trust also enjoys creditor protection. If you do not do this while you’re alive, your heirs can preserve inherited retirement assets by transferring the IRA they inherit to a “see-through trust.” This type of trust enjoys the same tax-deferred treatment that the beneficiary would enjoy had he inherited the IRA directly, but with far better protection from creditors in the wake of a bankruptcy filing or creditor lawsuit.
Be aware that in July 2014, the Supreme Court unanimously upheld a Seventh Circuit decision (Clark v. Rameker) that an inherited IRA was not protected in a bankruptcy proceeding. This was a specific case in which the IRA beneficiary claimed her inherited assets should be protected against creditors, demonstrating that these protections may come under scrutiny going forward on a case by case basis.