The number of personal bankruptcies in America has skyrocketed over the past few decades, and the fallout from this alarming trend can last for years for those who choose bankruptcy as the solution to their financial dilemmas. In 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Law into effect. This law made it much tougher for Americans to escape their financial obligations by declaring personal bankruptcy. (For more, read Should You File For Bankruptcy?)

TUTORIAL: Credit and Debt Management

More Protections for IRAs
However, a ruling on this law by the Supreme Court in April of 2005 provided an additional layer of protection to individual retirement accounts (IRA), the tax-deferred vehicles that many Americans use to save for their nonworking years. The new bankruptcy law stipulates that $1 million of money in either a traditional or Roth IRA belonging to anyone declaring bankruptcy is automatically exempt from the bankruptcy estate and cannot be attached by creditors (other than the IRS) under any circumstances.

The bankruptcy court has the leeway to exempt a larger amount if it deems it appropriate to do so. This protection also extends to any balance in an IRA that was rolled over from a 401(k) or other qualified plan, and also reinforces the protection that assets in those plans have always enjoyed under ERISA guidelines. The new law even protects any rollover money that is constructively received by the plan or account owner, as long as it is rolled back into an IRA or qualified plan within 60 days. This rule effectively differentiates between contributory IRA money, to which the $1 million exemption applies, and rollover money, which has no dollar limit and therefore receives unlimited protection. Those with large IRA balances who are contemplating bankruptcy should take care to keep these monies separate in order to maximize their benefit from this rule. (For more on retirement plans, check out Which Retirement Plan Is Best?)

Roy has $1.5 million in a contributory IRA and another $675,000 in a rollover IRA at the time that he declares bankruptcy. The first million dollars of his contributory IRA is exempt from creditors in addition to the entire balance in his IRA rollover account.

The protection that this law gives to IRAs and IRA rollovers can make them even more attractive for high-income taxpayers who work in professions that are frequent targets of lawsuits, such as the medical field. These accounts are now safe not only from taxation, but also from creditors, in most instances, which makes them ideal vehicles for substantial assets. The new law also makes the rules pertaining to attachment from these accounts much clearer for the courts, where the law varied substantially from one state to another regarding this issue. BAPCPA also eliminates one of the reasons why some retirees chose to leave their plan balances with their former employers instead of rolling them over to an IRA, because IRAs now enjoy the same protection in bankruptcy as their ERISA-sponsored cousins. This law has therefore prompted a number of IRA rollovers that give taxpayers greater freedom and control of their assets during retirement.

The Bottom Line
The new law does not provide carte blanche protection from creditors in all circumstances and situations. Any normal distribution that is taken from an IRA or qualified plan is subject to attachment from creditors, including Required Minimum Distributions and hardship withdrawals. The law also does not extend protection to IRA monies outside of bankruptcy; creditors may attach IRA assets in many cases if bankruptcy is not declared (depending on state law). BAPCPA also does not prevent Qualified Domestic Relations Orders (QDROs) between divorcing spouses. For more information on how bankruptcy or other creditor claims can affect your IRA, consult a bankruptcy attorney or your financial advisor. (For more, see 5 Myths About Personal Bankruptcy.)

Related Articles
  1. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  2. Professionals

    How to Protect Retirement and Help Adult Kids

    Parents can both protect their retirement money and help their adult kids. Here's how.
  3. Retirement

    10 Ways to Save Your Retirement: It's Not Too Late

    It's not too late to start saving for your retirement, even if you took longer to start thinking about it and doing something about it.
  4. Investing

    Why Is Financial Literacy and Education so Important?

    Financial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
  5. Investing

    10 Ways to Effectively Save for the Future

    Savings is as crucial as ever, as we deal with life changes and our needs for the future. Here are some essential steps to get started, now.
  6. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  7. Professionals

    How to Protect Your Portfolio from a Market Crash

    Although market crashes are usually bad news for your portfolio, there are several ways to minimize losses or even profit outright from market movement.
  8. Professionals

    Why Women Are Underprepared for a Spouse’s Death

    Women are typically less prepared for the death of a spouse than men. An advisor can help mitigate some of the financial burdens widows may end up facing.
  9. Professionals

    3 Benefits of Working Longer (and Retiring Later)

    There are many reasons why folks in their 60s may want to keep working until at least age 70. Here are three.
  10. Retirement

    What Does It Cost to Retire in Costa Rica?

    Tally up the costs associated with taking your retirement in Costa Rica, and determine whether you have what it takes to live in paradise.
  1. Can creditors garnish my IRA?

    Depending on the state where you live, your IRA may be garnished by a number of creditors. Unlike 401(k) plans or other qualified ... Read Full Answer >>
  2. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  3. How can I determine if a longevity annuity is right for me?

    A longevity annuity may be right for an individual if, based on his current health and a family history of longevity, he ... Read Full Answer >>
  4. How does a Roth IRA grow over time?

    Your Roth IRA account grows over time thanks to two funding sources: contributions and earnings. While your contributions ... Read Full Answer >>
  5. Can my IRA be taken in a lawsuit?

    Whether your IRA can be taken in a lawsuit depends largely on your state of residence and the judgment in question. There ... Read Full Answer >>
  6. Can my 401(k) be seized or garnished?

    As long as your retirement funds are held in your 401(k) and you do not take them as distributions, your 401(k) cannot be ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!