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The Smartest Reason to Max Out Your 401k and IRA Contributions

By John Maxfield - Sep 12, 2015 at 6:08AM

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Qualified retirement accounts will generally shield your assets from creditors.

Accidents happen. But even in a country as litigious as the United States, there are ways to protect your assets and hard-earned money from creditors and others set to deprive you of them.

The most obvious way is to set up an irrevocable trust, which are designed to protect the assets therein in the event that you get sued for all your worth. Generally speaking, the assets in a trust aren't vulnerable to creditors because, in the legal fiction underlying trust law, you don't possess the assets. They're owned instead by the trust itself, which is a separate legal entity, and possessed by the trustee, who is often a separate person.

The keys to establishing a valid trust are threefold. First, you, the "settlor," must transfer the assets into the trust. Second, you must designate a trustee -- who could be anyone, including yourself. Third, you must designate the "beneficiaries" who are entitled to the income produced by the trust.

Assuming you meet these requirements, as well as any other standards under the state's trust laws in which the irrevocable trust is formed, you can rest easy knowing that the assets contributed thereto are generally safe from the prying eyes of anyone set on depriving you of them.

A second way to shield your assets from potential creditors or litigants is to stash them in a qualified retirement plan -- namely, an IRA or 401k. Of all the benefits associated with legally sanctioned retirement plans, this is second only in significance to the substantial tax benefits they offer.

To be clear, not all types of retirement accounts will protect your assets from judgment creditors -- that is, someone you owe money to as a result of a lawsuit. This depends on whether or not the plan is qualified under the Employee Retirement Income Security Act of 1974, or ERISA. While there are multiple features that a retirement plan must satisfy to qualify for this protection, one type of account that generally does meet the requirements is the 401k.

Consequently, and this is an important point, regardless of how much you have contributed to your 401k, the amounts therein are yours and yours alone. Even if you're found liable for a multi-million dollar legal claim, the opposing party can't touch your 401k -- except, that is, when the creditor is either a former spouse or the IRS.

Individual Retirement Accounts, or IRAs, don't offer the same level of protection, but they, too, provide some shelter from creditors. In this case, as explains here, when a person files for bankruptcy protection, the assets in their IRA are exempt from creditors up to roughly $1.25 million. Thus, even assuming the worst-case scenario in which a creditor's claims vastly exceed your net worth, you should nevertheless be able to maintain ownership over your primary residence and, at the very least, a substantial portion of your IRA.

At the end of the day, there are a seemingly endless number of arguments in favor of maxing out your legally sanctioned retirement accounts. However, few are more powerful than the legal protection that these accounts provide to your hard-earned money and assets.

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