Creditor Protection for IRAs

The good news is that most individual retirement accounts (IRAs) are protected from the claims of judgment creditors. The not-so-good news is that not all IRAs are creditor-proof. As a result, some basic estate planning strategies may be impacted by limited exempt property statutes and other judge-imposed limitations when it comes to protecting wealth held in an IRA.

Exempt Property Statute: Michigan’s exempt property statute provides an extensive list of assets that cannot be taken by judgment creditors to satisfy their judgement. Sadly, that statute is not current in many of its provisions that are intended to protect a debtor’s assets. For example, statute protects farm animals and only $3,500 of home equity. Most folks no longer own farm animals to sustain themselves and their families. A quick skim of Michigan’s exempt property statute leads to the conclusion that it is long-overdue for an update to bring it into the 21st century.

IRAs are Protected from Creditors: As noted above, the good news is that Michigan’s exempt property statute lists both traditional IRAs, Roth IRAs, and retirement annuities, as protected or exempt assets.

Exception Creditors: Under the Michigan exempt property statute though, a judgment creditor will not be prevented from reaching IRA assets if contributions were made by the IRA owner within 120 days of filing for bankruptcy or they are nondeductible or after-tax IRA contributions made to the IRA. Nor will the exempt property statute bar claims of a former spouse under an order that is entered by a divorce court, i.e., the owner’s IRA can be divided in a divorce.

All other judgement creditors are unable to reach the debtor’s traditional IRA or a Roth IRA, regardless of the amount or value of that IRA.

Inherited IRAs: Currently the Michigan exempt property statute does not protect inherited IRAs. Accordingly, an inherited IRA is not protected from the reach of the judgement creditors of the debtor who inherits an IRA (either a traditional or Roth IRA.) There is currently interest in some circles to add inherited IRAs to the extensive list of statutorily exempt property categories, so inherited IRAs in the years to come may become protected. Currently, eight states now extend their statutory creditor protection to inherited IRAs: Alaska, Arizona, Florida, Idaho, Missouri, North Carolina, Ohio, and Texas. A beneficiary who lives in one of these states who inherits an IRA should take some comfort in knowing that their inherited IRA will be protected by their resident-state’s statute.

Bankruptcy: Federal Bankruptcy law exempts a maximum dollar amount held in an IRA (but not an inherited IRA) from inclusion in the bankrupt’s estate that is divided among the debtor’s creditors. That maximum amount of protection is $1,512,350 in 2024-2025. Retirement funds held in a qualified plan, like a 401(k) account, are protected with an unlimited amount of creditor protection so long as the funds remain held in the employer-sponsored retirement plan.

More importantly, if funds held in an IRA can be ‘traced’ back to amounts that were rolled into the IRA from a qualified plan account, like a 401(k) account, then those traceable funds held in the IRA can exceed the $1,512,350 IRA dollar-limited protection. For example, if the IRA owner held an IRA with $1.5 million and she rolled another $2.0 million into her IRA from her 401(k) account on retirement, the entire balance of her traditional IRA, or $3.5 million, is protected in bankruptcy. That is why it is important to be able to ‘trace’ IRA funds back to their origin when retirement plan contributions were accumulated in a qualified plan account.

Only One IRA: Unfortunately, according to one federal bankruptcy court based in Michigan, only one IRA is protected from creditor claims in Michigan under the Michigan exempt property statute. This conclusion was reached by that federal judge who focused on the language used in Michigan’s exempt property statute, which identifies as exempt property “An individual retirement account or individual retirement annuity as defined in 408 [traditional] or 408A [Roth].” The bankruptcy judge felt that if the Michigan Legislature wanted more expansive protection for a debtor’s IRAs, it could easily have used the words ‘any, or all, or a specific enumeration or amount.’ If that narrow interpretation is accurate, then an individual who owns both a traditional IRA and a Roth IRA can have one of their IRAs taken to satisfy a creditor’s judgment. [In re Spradlin, U.S. Bankruptcy Court, 1999.]

Hopefully, an amendment will be considered to Michigan’s statute to clarify that more than one IRA can be protected under the exempt property statute with so many individuals now encouraged to convert some of their traditional IRA to a Roth IRA as part of their retirement planning. This narrow interpretation of Michigan’s exempt property statute tends to overlook the ease of an IRA owner to consolidate two or more traditional IRAs into a single IRA (or the same for two or more Roth IRAs) and thus shelter those combined retirement investments from the claims of a judgment creditor.

Planning Implications: These rules and the currently narrow interpretation of how many IRAs are protected, can lead to planning complications when it comes to owning IRAs and the steps that can be taken to protect them from creditors. Consider the following:

1. Tax Burden Does Not Shift: It is bad enough for the owner to lose his IRA to a judgment creditor. Added to that loss of wealth when the creditor takes the traditional IRA in satisfaction of its judgment is the fact that it becomes a taxable distribution to the IRA owner, not the judgment creditor. The IRA owner is the one who is treated as taking a taxable distribution from his or her IRA, and it is the IRA owner who must pay the income tax burden associated with that distribution. This tax consequent can lead to a bunching of that tax deferred taxable income into the year that the IRA is taken by the creditor, at marginally higher income tax bracket.
2. Segregated Self-Directed IRAs: Some IRA owners want to use self-directed IRAs to invest in private equity investments or other higher-risk investments. Those self-directed IRAs are dangerous since their investments are often opaque, illiquid, and hard-to-value. There is also a higher risk of self-dealing prohibitions with a self-directed IRA which can lead to the traditional IRA no longer being qualified as a tax-deferral device. The risk that the IRA is no longer tax exempt can be mitigated to some extent if the self-directed IRA is held separate from ‘other’ retirement investments held in another traditional IRA. If the self-directed IRA runs afoul of IRS’s prohibited transaction rules, then the entire IRA loses its tax-exempt status. By segregating the private equity investments into their own IRA addresses the risk by protecting the other, more conventional, investments held in the ‘other’ IRA. If Michigan’s statute only protects one IRA, and the self-directed IRA holds hard-to-value, illiquid, assets, the judgment creditor may quickly pursue the conventional IRA to satisfy its judgement. Segregating risk-oriented investments from traditional investments in separate IRAs may be a good tax-planning strategy, until the realization that only one IRA may be protected under Michigan’s exempt property statute.
3. Inherited IRAs: With the SECURE Act, most inherited IRAs must be ‘emptied’ within 10 years of the IRA owner’s death. Many who inherit an IRA leave the assets in the IRA for the full ten years, to exploit the tax-deferred growth of the inherited investments. Someday the inheritor will have to pay income taxes on the inherited IRA and its future growth when its assets are distributed. Since an inherited IRA is not protected from creditor claims under Michigan’s statute (but may be protected if the inheritor lives in a state which protects inherited IRAs), if the inherited IRA is seized in satisfaction of a judgment, that just means more taxable income will be attributed to the inheritor in a single year. If the inheritor has his or her own traditional IRA, it is better to ‘spend-down’ the inherited IRA first before tapping into the inheritor’s own IRA (traditional or Roth.).
4. Roth Conversions: There are several good tax reasons to convert a traditional IRA to a Roth IRA. Unfortunately, many current Roth conversions are made over an extended period when sufficient non-IRA assets become available to pay the federal income tax due on the partial Roth IRA conversion. That said, many of these installment conversions lead to two separate IRAs, a traditional IRA slowly being depleted by the annual conversions, and a slowly growing Roth IRA. Once again, there are two IRAs owned by the individual, and only one is protected under Michigan’s exempt property statute according to one federal bankruptcy judge.
5. Qualified Plan Rollovers: When an individual retires from their employment, he or she often rolls over their retirement account balance, like a 401(k) account, to an IRA, where they feel that they have far more control over their investment choices. As noted above, if these assets held in a rollover IRA can be ‘traced’ to their retirement plan origin, then they are not limited to the artificial dollar amount that protects a traditional IRA in a future bankruptcy. When I practiced law I often encouraged that the rollover from the qualified plan be placed into a separate IRA (apart from any traditional IRAs that the owner maintained outside of his or her retirement plan savings) just so that ‘tracing’ back to the retirement account could be easily determined, and thus the ability to navigate around the bankruptcy’s $1,512,350 dollar limit of IRA protection. With the one IRA protected under Michigan’s statute, that segregation of traced qualified plan assets may prove to be bad advice, since if the 401(k) funds are added to the traditional IRA held outside of the qualified plan, all those retirement funds, regardless of their value, will be protected because they will be held in one IRA account.

IRAs now comprise a substantial part of an individual’s net worth, often with balances in the millions of dollars. Individuals are encouraged, both by financial planners and by Congress [see the SECURE Act 2.0] to open Roth IRAs. Keeping those IRA assets protected from potential creditor claims is an important part of any estate plan. But not all IRAs are protected, at least under Michigan’s exempt property law as it is currently written. Until the statute is rewritten or clarified by a Michigan court, it is best to hold all assets in a single traditional IRA, or a single Roth IRA. Hopefully, too, Michigan’s statute will be interpreted to protect both traditional and Roth IRAs, so that a choice does not have to be made by an owner “which of my IRAs do I ‘protect’?”