Planning for Retirement Plans and IRAs: Asset Protection

Retirement assets, including 401(k)s, IRAs, etc., comprise a large portion of the average American’s wealth. Planning for these assets is critical, not just due to their value, but also due to their special nature.

Traditional IRAs and 401(k)s and the earnings on them are tax-deferred. Roth IRAs and 401(k)s are tax-free. However, there’s another characteristic of these plans which is the subject of this memo.

Both traditional and Roth accounts share asset protection during the life of the person who contributed to the account, otherwise known as the “Participant.” A Participant’s IRA has protection under federal bankruptcy law to at least $1 million (adjusted for inflation), while a 401(k) has unlimited protection under federal bankruptcy law. (An IRA may have greater protection under state law.) However, upon the Participant’s death, the accounts lose all bankruptcy protection, whether IRA or 401(k), Roth or traditional due to the Supreme Court’s decision in Clark v. Rameker.

But let’s see what happens after death. Betty had a $2 million IRA. On the IRA beneficiary designation form, she designated her IRA equally to her two children, John and Sally. Betty trusted John’s judgment but did not trust Sally’s. Betty left John’s share of her IRA outright to him. Betty designated Sally’s share of the IRA to a trust which Betty had set up for Sally’s needs.

John and Sally got along well, so they shared ownership of a lake home. When they didn’t use it, they rented it. Neither John nor Sally focused on upkeep. So, they didn’t bother to repair the property’s dock when they heard creaking boards and saw the trail of termites. A renting family decided the dock was a perfect spot for a vacation photo. Unfortunately, the dock collapsed and they were seriously injured. They sued John and Sally and got a judgment for $5 million against each of them.

Since Betty had left John’s share of her IRA outright to John, the creditors could seize his share of the IRA. However, Betty had left Sally’s share of the IRA to a trust for her benefit. The trust allowed for distributions to Sally only in the trustee’s discretion. Because the IRA had been left to the trust for Sally, the creditors could not reach Sally’s share of the IRA.

At Betty’s death, the protection inherent in the IRA under federal bankruptcy law evaporated. However, the IRA still could be protected in a different way. The discretionary trust for Sally provided its own asset protection. The IRA which Sally’s trust received at Betty’s death had no asset protection itself. But, the trust “wrapper” provided protection.

If Betty had left John’s share of the IRA in trust, he would not have lost it to creditors and he would have had access to it in the future. IRAs and 401(k)s enjoy asset protection in bankruptcy during the life of the Participant.