Financial lawsuits can be a nightmare in more ways than one. One potential result with long-term consequences is a full or partial seizure of your retirement plan. If you end up losing a lawsuit, the creditor may be able to go after most of your assets for payment, including certain retirement plans.
While some plans are fully shielded from lawsuits under federal law, others are not. Depending on your plan and your state of residence, the assets in your retirement plan will have varying levels of protection. Of course, most people never intend to be involved in a lawsuit, but it is always better to be safe than sorry. Here is a quick explainer on retirement plan asset protection, and how you can keep your money as secure as possible.
ERISA work retirement plans
Large employer-sponsored retirement plans like 401k’s, profit sharing plans, and pensions offer the best protection against lawsuits. These plans fall under a federal law known as the Employee Retirement Income Security Act, or ERISA, which stakes out important protections and standards around retirement plans. As part of the law, your benefits under an ERISA-eligible retirement plan can never be taken away by another party, meaning it is safe from collections stemming from most lawsuits. In addition, since it is a federal law, ERISA protections apply no matter where you live in the United States.
However, there are a few special types of lawsuits in which the creditor could still take some of your retirement savings. For example, if you get divorced, your ex-spouse could receive some of your retirement plan value as part of the divorce settlement. Or, if you do not pay the taxes you owe to the IRS, the agency could force payment through your retirement plan. if you are facing a fine from a federal criminal judgment. In this example, the government may be able to seize funds from your retirement plan.
Non-ERISA retirement plans
Not all retirement plans fall under federal ERISA standards. IRAs and small business employer plans like SEPs and Simple IRAs are excluded from ERISA protection, so each state sets its own rules and the level of protection for these plans varies across the country.
Some states, like Ohio, offer very strong protections that could potentially shield your entire account from lawsuits. Others, like Nevada, set a protection cap, so that a maximum of $500,000 of your balance is safe from seizures, leaving anything above that threshold potentially open to creditor seizures.
Still other states, like California, do not offer pre-set limits. Instead, the court reviews your personal financial situation on a case-by-case basis to decide whether you can afford to lose the IRA money. If you have a large amount in your IRA and are relatively young (and thus able to replace any lost funds), you are more likely to have your IRA savings taken through a court decision. You should review the creditor protection laws in your state to better understand your exposure to potential lawsuits.
Even if your plan is protected against normal creditors under state law, there are still situations in which you could be forced to make a withdrawal- for example to settle a divorce or pay back taxes to the IRS.
Strategies to protect your IRA
If you want to invest through an IRA plan without ERISA protection, but are worried increased exposure to lawsuits, a rollover could be a good option. If you transfer money from an ERISA-covered plan to an IRA, those transferred funds retain the same ERISA protection against lawsuits. This could be a useful move if you want to take advantage of the expanded investment options in a self-directed IRA, without sacrificing legal protection.
If you are currently facing a lawsuit and already have money in a Traditional IRA, you could make a Roth IRA conversion in an attempt to protect more of your savings. Because many states set a minimum balance as a threshold to decide whether the creditor will receive any of those funds, it is in your interest to minimize the funds in that account. Lowering your IRA balance through a conversion could push you below that threshold, thus leaving your assets whole.
Note that when you make a Roth IRA conversion, you first need to pay income tax on the money in your Traditional IRA, but your investment earnings are income-tax free from that point forward. Generally speaking, it is better to pay the taxes on a Roth conversion rather than losing that money to the creditor.
If you ultimately lose your lawsuit and your financial position is irreparably harmed, you could consider declaring bankruptcy in order to protect your IRA. You are able to exempt up to $1 million in an IRA from creditors during bankruptcy, which would be useful if you live in a state that offers minimal IRA protection.
Before taking any action, you should always first consult with a legal expert who understands the creditor protection rules and your particular situation.