How to protect your retirement from lawsuits

Workplace defined-contribution plans and IRAs are key for growing your money tax-deferred until you withdraw your savings at a later date. Hopefully, this is when all of your hard work pays off, while you’re laying on a beach somewhere, reaping the benefits of your tax-deferred savings plans and the strategic advice from your wealth managers. Getting sued is just one of those life events that no one really plans for. However, like divorce or the loss of a loved one, unfortunate events do happen, often with huge financial implications. The best way to deal with the prospect of a negative situation is to protect yourself from the potential pitfalls in advance.

Nothing makes a situation worse than a blindsided hit, where your assets can be taken from you along with the emotional burden of the circumstance at hand. For those late in their careers, a lawsuit could potentially wipe out their retirement savings. A survey by ICI Research Perspective showed that 63% of all U.S. households had retirement plans through work or IRAs, and one third of U.S. households owned traditional IRAs and Roth IRAs in 2014. Much of the growth in IRA accounts results from employer-sponsored retirement plan rollovers.  

Retirement accounts have many additional benefits, apart from their well-known tax advantages. This is great news for the majority of Americans, as it turns out that one of the most effective ways to protect assets is to shield them in retirement accounts. Individual retirement accounts, 401(k)s, IR’s and other types of tax-efficient plans can help you prevent the loss of your assets in case of a lawsuit. At the federal level, the rules are clear for 401(k) and employer-sponsored retirement accounts. State laws are more complex when it comes to whether or not IRAs are fair game in case of a lawsuit.

The Retirement Plan Shield

First and foremost, make sure that you do not owe any child support or taxes to the IRS, since this will open up your accounts to lawsuits. Domestic relations lawsuits will lift IRA protections anywhere you reside within the country.

If you owe taxes to the IRS, your retirement assets may be fair game just like any other asset that can be seized from you to settle the unpaid debt. The federal government will not change any rules associated with minimum withdrawal rules in case of a lawsuit, and will charge a 10% early withdrawal rate if you are extracting money in reaction to your lawsuit.

In the event of a private creditor suing for unpaid debt, retirement accounts are usually protected, despite some exceptions to the rule. The Employee Retirement Income Security Act (ERISA) relates to federal protection of 401(k) and other employer-sponsored retirement accounts from creditors. The federal government ensures the safety of these accounts to protect retirement even in case of a lawsuit. Up to $1 million of a defendant’s IRA will be protected under the Bankruptcy Abuse Prevention Act of 2005.

However, in June of 2014, the U.S. Supreme Court decided that inherited IRAs will no longer be sheltered if the inheritor files for bankruptcy – with the exception of IRA being inherited from a spouse.

Profession-Specific

Business owners, entrepreneurs and other self-employed individuals should be aware of the issues that can arise in case of a lawsuit, which can not only damage the company, but also their personal assets. To hedge against the risk of personal injury, business owners need to register as a limited liability company (LLC) or an S corporation. (To learn more, see: "Don’t Get Sued: 5 Tips To Protect Your Small Business.")

If your field of work has a history of frequent lawsuits, it might be best to create an asset protection trust. Fields where this may be particularly beneficial are real estate, health, and the law itself. According to Galfand Berger LLP, the average annual number of medical malpractice lawsuits filed each year was 85,000. Professional malpractice insurance can be relatively inexpensive, and should be used to save professionals around the U.S. the stress of a wishy-washy consensus on IRAs. 

Local Nuances

Laws regarding retirement protection in the event of lawsuits vary state by state. Angry creditors will not be stopped by many states from seizing your retirement and IRA accounts.

For example, California is a very risky state in which to own a retirement account if you are being sued or filing for bankruptcy. In California, IRAs are not as well protected as 401(k)s. What this means in practice is that if you are being sued for personal injury in California, your 401(k) will be protected from the prosecutor; however, your IRA will only be protected up to the point that the court deems necessary. The judgment will be based on a certain threshold that the court says will be sufficient to support you and your dependents in retirement.

This should alarm many planning for retirement, as there is no specific threshold in place, and future events are far from predictable. Any amount above what is decided will support you in a retirement of frugality is subject to the creditor's claim.

It is important to note that New Mexico and New Hampshire have no laws protecting IRA savings in case of lawsuits. On the other hand, the best states for IRA protection in a lawsuit are Texas, Washington and Arizona. In Arizona, only IRA contributions made within 120 days of the lawsuit are exposed to risk by the claimant.

Although there are established distinctions between states, it is important to understand that the law is never clear-cut. There may not be a straight answer for the outcome of your lawsuit, subject to type of account (Roth IRA, traditional IRA, etc.) and local jurisdiction. For example, you may have greater protection of funds inside of your IRA account as opposed to those outside, even if they consist of distributions from the account.

Moran Knobel, a certified retirement plan consulting and administration firm, offers a comprehensive state-by-state list of laws protecting IRAs and provides an analysis of individual retirement accounts as exempt property.

Remember Your Umbrella

To those with assets tied to retirement plans and IRAs, acquiring an umbrella insurance policy may help shield against the possibility of a creditor dipping into retirement accounts. Personal umbrella insurance can be added on top of your pre-existing homeowner​s insurance and auto insurance and will cover the excess cost in case of a catastrophe.

An attractive feature of an umbrella insurance policy during a lawsuit is that the insurance company is required to provide you legal defense on top of the coverage you already receive. It is important to note that umbrella policies do not cover business activities, intentional acts (such as sexual harassment) or punitive damages. In the case of a lawsuit, if you are required to pay out a claim, the umbrella insurance will come to play when your standard liability insurance has run out.

Umbrella insurance policies and professional malpractice insurance are two great ways to safeguard your IRAs. In this case, you can still receive the benefits of IRAs, which are more attractive due to the lower associated fees and investment flexibility in comparison to other employer sponsored plans and 401(k)s. (To learn more, see: "It’s Raining Lawsuits: Do You Need An Umbrella Policy?")

The Bottom Line

It’s important to put in place basic safeguards to protect your retirement against lawsuits and bankruptcy. The federal government has laws in place to protect many retirement accounts, including 401(k) and employer-sponsored plans. When it comes to IRAs, states have a greater jurisdiction in deciding what is up for grabs in the case of a lawsuit. 

If you are planning to retire, or have many assets in retirement and IRA accounts, you may want to look into moving to a state with heavy protection of these accounts. To avoid kicking yourself later, in a trailer or jail somewhere, make sure to be proactive in safeguarding your retirement – whether it be through malpractice insurance, umbrella insurance policies, or simply understanding the laws. As the laws are complex and often contain tactic loopholes, it may be in your best interest to consult a legal professional.