Asset Protection for IRAs

What is the best way to ensure that an Individual Retirement Account (IRA) is protected from the claims of creditors? As with any asset, developing a protection plan should include considering the following questions: Is the asset already protected by state or federal statute? Can the asset be moved or the owner's residence changed so that the asset would be protected by the statutes of a different jurisdiction? Can an unprotected asset be converted to a protected asset? Can the asset be protected by incorporating a protective structure?

Applying this framework to IRAs, the first consideration is whether the IRA is already protected by state or federal statute. The 50 states and the federal government provide a patchwork of statutory protection for various types of assets in various scenarios. IRAs are protected up to $1 million under federal bankruptcy statutes.

However, states may "opt out" of the federal exemptions and require that debtors filing for bankruptcy in a district within that state be subject to the state exemptions instead. While some federal bankruptcy provisions will always trump state law, the IRA provisions do not. California, for example, has opted out of the federal exemptions and only offers limited protection for IRAs.

If an asset is not already statutorily protected, the next question is whether the asset can become statutorily protected by utilizing the laws of another state. For example, Florida has very liberal asset protection laws for real property, so purchasing a property in Florida can offer protection from creditors. However, since IRAs don't have a distinct physical location, they tend to be governed by the owner's state of residence; and the only alternative would be to move and establish residency in a state that protects IRAs, such as Washington state.

If changing domicile is not an option, another is to convert an asset that is not protected into an asset that is protected. Converting cash to real estate is one example mentioned previously. Given the special tax treatment of IRAs, any such strategy would need to avoid tax penalties. While IRAs may not be protected in a particular state, 401(k) and other ERISA-qualified retirement plans are under federal law that trumps any state law affording 401(k)s less protection. In Patterson v. Shumate, 504 U.S. 753 (1992), the United States Supreme Court confirmed that creditors may not reach an individual's interest in ERISA-qualified plans, whether in a bankruptcy, lawsuit, or otherwise.

However, only certain kinds of IRAs can be rolled into a 401(k). Inherited IRAs may not be rolled into a 401(k), neither can non-deductible IRA contributions. Only IRA funds that constitute tax-deductible contributions or a previous 401(k) rollover can be rolled over into a 401(k). Furthermore, the employer and the 401(k) plan administrator must approve the rollover.

If converting the non-protected asset into a protected asset is not an option, placing the asset into a protective structure such as an irrevocable trust or LLC should be considered. Almost without exception, income-producing property such as rental real estate should be owned by an entity, probably an LLC, for asset protection purposes. While the owner of an IRA must be the individual, an LLC can still be incorporated by changing the investment of an IRA to a limited liability company with a friendly manager. This will work to invoke the protections provided by LLC statutes. In order for this strategy to work, the IRA must be managed by a custodian that allows self-directed investments.

In summary, if an asset is not protected by state or federal statute, consider whether it can be moved or the owner's residence changed, whether the unprotected asset can be converted to a protected asset, or whether the asset can be protected by incorporating a protective structure.

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