If you enter bankruptcy, can creditors claim the contents of your traditional IRA? Not always, according to the Supreme Court's recent unanimous ruling on Rousey v. Jacoway. But if you assumed that the justices made IRAs untouchable to bankruptcy creditors, think again.
The court's ruling was limited in scope; it doesn't grant IRAs the same protections as retirement plans covered under ERISA, the Employee Retirement Income Security Act. Qualified plans, including normal employer pension and profit-sharing, 401(k), 403(b), 457, and SIMPLE plans, have long been granted near-absolute exemption from creditor claims in bankruptcy. But IRAs aren't covered by ERISA, which has often complicated bankruptcy proceedings.
Some states protected IRAs, but others didn't. Even the various U.S. Circuit Courts couldn't agree on IRA accounts' vulnerability in bankruptcy. While the Supreme Court decision did provide some much-needed direction, it didn't necessarily end the confusion.
To determine whether the Rouseys' IRA accounts would be protected under bankruptcy proceedings, the court employed three basic tests under the Bankruptcy Code. The IRA would be protected if:
- The right to receive the payment came from a "stock bonus, pension, profit-sharing, annuity, or similar plan or contract."
- The right to receive payment was "on account of illness, disability, death, age, or length of service."
- The right to receive payment was "reasonably necessary to support" the debtor and/or his or her dependents.
The court said that IRAs "have the same primary purpose" as protected retirement accounts, "namely, to enable Americans to save for their retirement." That makes good sense, and satisfies the first of the three tests. The court also said that the right to receive payment from an IRA is derived from age -- after all, you're penalized for "early" withdrawals from a traditional IRA and required to take minimum distributions six months after your 70th birthday. So age clearly is a factor, which satisfies the second test. The third test, dealing with the "reasonably necessary" standard, was not presented before the court, but could be a big wild card. More on this later.
A simple reading of the court's decision could suggest that IRAs get absolute bankruptcy protection -- but that's not the case. For one thing, not all states use the federal bankruptcy exemptions. Some states have their own bankruptcy exemptions, which don't always compare favorably with federal statutes. In some states, you can choose between state and federal statutes, while other states permit only state rules or federal rules. Since the ruling applies only to federal statues, citizens limited to using state bankruptcy statutes are out of luck.
And let's not overlook the "reasonable support" test noted above. In the Rousey case, their IRA totaled about $55,000 and wasn't contested -- under the circumstances, it was certainly reasonable. But what about an IRA with a $1 million balance? $2 million? More?
After all, most IRAs grow from funds rolled over from an employer plan when you leave a job or retire. I have many clients with IRAs well into seven figures. Those IRAs would escape creditor claims only to the extent that the funds they contain are "reasonably necessary to support" their owners and dependents. Obviously, that's more of a judgment call than a sure thing, so don't bank on it.
Up until now, we've been discussing traditional IRAs. Do Roth IRAs also get the same protection? Probably not. In addition a few minor issues, they fail the second test above: A Roth IRA lets you withdraw contributions penalty-free at any time and demands no minimum distribution.
Despite the court's ruling, there are still many grey areas surrounding IRAs and bankruptcy. If you're worried about going bankrupt, don't avoid rolling over your qualified employer retirement plan to your IRA -- just exercise reasonable care in doing so. At the very least, hire a qualified bankruptcy attorney in your state to discuss the transfer. If disaster strikes, at least you'll know where your IRA stands.
When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns, as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.