Take-Away: Most retirement accounts are protected from creditors or in a bankruptcy proceeding. Note the use of the word most. As with almost all of the retirement planning, there are multiple rules that apply to different types of retirement plans, including federal rules (ERISA), federal bankruptcy rules, and state-specific creditor protection exemption rules. As a broad generalization, it is never a good idea to make assumptions about when creditor protection exemptions are available, and when they are not. This will become important as the aftermath of the economic collapse caused by COVID-19 starts to make its way through the economy, with so many businesses closing and individuals losing their jobs.

Background: What follows is a summary of some of the basic creditor protection rules for an individual’s retirement assets.

Michigan: Michigan law exempts qualified retirement accounts, IRAs, Roth IRAs, and retirement annuities from the claims of creditors outside of bankruptcy. However, this state exemption from creditor claims does not apply to: (i) amounts contributed to a qualified plan or IRA or an individual retirement annuity within 120 days of filing for bankruptcy; (ii) qualified domestic relations court orders [QDROs] incident to a divorce (spousal support, child support, or property division); or (iii) nondeductible contributions made to an IRA. [MCL 600.6023(k)(l).]

  • One IRA Protected: However, Michigan’s creditor exemption statute refers to “an individual retirement account” that is exempt from a judgment creditor. Consequently, only one IRA is exempt from a creditor’s claims (outside of bankruptcy.) In re Katranji, No.93-CV-75304-DT (E.D. Mich, May 17, 1994); In re Spradlin, 231 B.R. 254 (Bankr ED Mich, 1999.) Therefore, if an individual has both a traditional and a Roth IRA and a judgment is entered against that individual, then one of those IRAs will not be protected under Michigan’s exempt property statute.

Federal Exemption for Qualified Plans: Qualified plans that are subject to the Employee Retirement Income Security Act (ERISA) also enjoy considerable creditor protection for an employee’s qualified retirement account. An unlimited amount held in a qualified plan account, like an 401(k) account is protected both against general creditor claims. ERISA requires that each qualified plan contain an anti-alienation clause that protects the amounts held in the retirement account from attachment by the participant’s judgment creditors.

  • Exception for Rollovers: If retirement funds are in the process of being moved from a qualified plan to an IRA, or from one IRA to another IRA, they are normally protected from creditor claims while the assets are not ‘wrapped’ inside the IRA or qualified plan, but in transit. One risk is with regard to the movement of retirement accounts in a bankruptcy setting. The protection afforded ‘moving retirement money’ from creditor claims is only available when the bankruptcy paperwork has officially been filed while the funds were still in the retirement account. In contrast, funds already ‘out’ and ‘in transit’ on a rollover when bankruptcy is formally filed lose all creditor protection.
  • Exception for Solo (401(k) Plans: ERISA defines a ‘pension plan’ as “any fund or program which…provides retirement income to [ERISA Section 3(2)(A).] Restated, any qualified plan that does not benefit a common law employee is not an ERISA pension plan. As a result, a solo 401(k) plan is not treated as an ERISA plan and not covered by the ERISA’s creditor protection exemption. Case law and the Department of Labor Regulations  hold that a solo 401(k) plan that benefits only the business owner (and/or the owner’s spouse) are not ERISA plans, which thus voids the anti-alienation protections normally afforded to ERISA covered plans. A solo 401(k) plan is still a retirement plan for retirement contribution, tax deferral, and distribution purposes, but not when it comes to keeping creditors away. Consequently, a self-employed business owner who is worried about lawsuits will not be protected any more than with an IRA (under the state’s IRA exemption statute) when retirement contributions are made to a solo 401(k) plan. Unlike qualified plans, an IRA is not covered by ERISA’s unlimited protection against general creditor claims, hence the desire to hold all retirement contributions in a 401(k) or other qualified plan account. But solo 401(k) plans, where only the owner (and the owner’s spouse) are the plan participants, are not covered by ERISA, so that the only creditor protection available to a solo 401(k) plan participant is the state’s general exemption protection. Unfortunately, Michigan’s exempt property statute [IRC 600.6023] does not mention solo 401(k) plans, so there is a legitimate question whether a solo 401(k) account balance is even protected under Michigan’s exempt property statute.

Self-Directed IRAs: While we normally only think of judgment creditors of the IRA owner when discussing creditor protection, sometimes the assets held in a self-directed IRA also need protection against creditor claims.

Example: Perry maintains a self-directed traditional IRA, with $750,000. In his IRA Perry has invested $100,000 in a company that rents 4-wheelers to tourists in a vacation mecca (Traverse City?). Perry did not use an LLC or corporation to take title to the 4-wheeler business. A tourist to whom Perry rented a 4-wheeler has a catastrophic injury. After extensive litigation, a jury returned a verdict in favor of the injured individual in the amount of $1.1 million. Perry’s IRA, the owner of the 4-wheeler business, and all of its assets are available to satisfy the $1.1 million personal injury judgment. If Perry had instead taken title to the 4-wheeler business in an LLC, while the LLC’s assets could be taken to satisfy the judgment ($100,000) the balance of the assets held in Perry’s self-directed IRA ($650,000) would have been protected and judgment-proof.

Inherited IRAs: In 2014 the United States Supreme Court unanimously held that inherited IRAs are not protected in bankruptcy. Clark v, Rameker (2014). In response to Clark, some states amended their exempt property statutes to protect inherited IRAs: Alaska, Arizona, Connecticut, D.C., Delaware, Florida.

  • Michigan: Under Michigan law, probably inherited IRAs are not protected in bankruptcy if federal exemptions are elected, unless the account is either (i) structured as a trusteed IRA or (ii) is payable to an irrevocable trust that contains a spendthrift provision. In re Zott, 225 BR 160 (Banrk ED Mich 1998.) So far there have been no reported cases in Michigan where an inherited IRA was involved and state statutory property exemptions were claimed. Two Michigan bankruptcy judges have held, one in 1994 and the other in 1999, that only one IRA is protected under Michigan’s exempt property statute. In 2005 when MCL 600.5451(k)(k) was enacted, it allows for an exemption of all IRAs for bankruptcy In contrast, MCL 600.6023(1)(j)- the exempt property statute, only an individual retirement account…..is exempt from a judgement creditor outside of bankruptcy.” Accordingly, only one IRA is exempt from levy and attachment outside of bankruptcy in Michigan.

Bankruptcy: An unlimited amount of assets held in a qualified plan is protected in a bankruptcy proceeding that involved the plan participant. [11 USC 522(b)(2).] This complete protection is afforded to 401(k) plans, SEP IRAs, SIMPLE IRAs, and non-ERISA covered retirement plans such as 403(b) annuities and 457(b) governmental plans.

  • Limited Protection: IRAs, which are not covered by ERISA, are given only limited protection if the IRA owner files for bankruptcy. The protected amount in the IRA (traditional or Roth) is currently $1,362,800 [which is adjusted annually for inflation.] This same protection is available for a Michigan IRA owner who files for bankruptcy. [MCL 600.5451(k)(l).] Fortunately, rollovers to an IRA are not included in determining this fixed dollar ceiling.

Example: Paul is a retiring orthopedic surgeon. Paul has $2,500,000 in his 401(k) account. Paul also has a traditional IRA with a balance of $700,000. Upon Paul’s retirement he rolls his 401(k) balance into his IRA. Paul’s entire IRA ($3,200,000) is shielded if he later has to file for bankruptcy. The bankruptcy code protects Paul’s traditional IRA amount ($700,000) and Paul’s entire former qualified plan account balance ($2,500,000.)

Suggestion: While the qualified plan account balance can be rolled directly into an existing traditional IRA and be protected in bankruptcy, for ease of administration, and to facilitate the proof the source of funds as a qualified plan it is better to establish a separate traditional IRA to receive only the rollover from the qualified plan to avoid any confusion.  Of course, this suggestion flies in the face of Michigan’s creditor protection statute which affords creditor protection to only one IRA. 

Conclusion: There is considerable protection to retirement accounts from predatory creditors under both state and federal law, but it is not absolute. Before retirement funds are moved from one account to another, or rolled out, or rolled into, a qualified plan, it pays to go slow and think through the creditor protection aspects of the transaction, as well as the tax and investment implications of that move.