How Does Bankruptcy Affect Your IRA?

By Mark P. Cussen, CFP®, CMFC, AFC | December 23, 2011 AAA
How Does Bankruptcy Affect Your IRA?

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?)

Example
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.)

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