No Protection if No Employees

If a business has no employees other than owners, a Keogh plan does not receive federal creditor protection under ERISA. Often, business owners (especially doctors) who are worried about potential lawsuits keep their retirement funds in their Keogh accounts because they believe them to be fully creditor-proof. But that may not be the case if there are no employees participating in the plan. If there are no employees, Keogh owners receive creditor protection available under applicable state law (similar to the way IRAs are protected), which could be substantially lower than the protection afforded under ERISA. If this situation applies to any of your clients, they are probably better off rolling over the Keogh funds to an IRA upon retirement.

IRA Creditor Protection in Bankruptcy

Bankruptcy Law Grants Improved Level of IRA Creditor Protection
April 20, 2005
Effective: October 17, 2005

On April 20, 2005, President Bush signed the bankruptcy reform bill, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, into law.

A Silver Lining for IRAs
The law makes it much tougher on those who want to protect their assets in bankruptcy, but buried in the law is an oasis of protection for retirement accounts which are often the largest asset people have. The law expands the creditor protection afforded to IRAs that was previously granted by the Supreme Court. Bankruptcy protection for retirement accounts under this law may be so good that even con artists who profited by milking the old bankruptcy law might start funding retirement accounts to shield their ill gotten gains.

The provisions provide greater creditor protection for retirement plan assets, but only in bankruptcy. They do not apply to judgments awarded in other courts where state creditor protection laws will apply.

Effect on Retirement Accounts
The law revises the exemptions under Section 522(b)(3). Retirement funds that are in plans that are exempted from federal income tax under Code Sections 401, 403, 408, 408A, 414, 457, and 501(a) are now exempted from the bankruptcy estate. This covers qualified retirement plans (401(k)s, etc.), 403(b)s, IRAs, Roth IRAs, governmental plans, and tax exempt organization plans.

There is an inflation-adjusted cap of $1,000,000 on IRAs and Roth IRAs. This cap can be increased at the discretion of the Bankruptcy Court and it does not apply to certain rollover contributions. Since this cap applies only to IRA or Roth IRA contributions and earnings on those funds, the bankruptcy law protects virtually all funds in IRAs even if the total balance exceeds $1,245,475 (the inflation adjusted number). The reason that virtually all IRAs are protected is that it is unlikely that anyone has accumulated over $1,245,475 in an IRA from making annual IRA contributions, even if they have contributed for the 30 plus years that IRAs have been available. If the maximum was contributed to an IRA each year from 1975 to 2013, there would be $102,000 in contributions ($112,000 if the IRA owner qualified for the age 50 or over catch-up contributions available beginning in 2002). It is unlikely that the earnings, even for those who contributed the maximum each year, would push an IRA balance to over $1,245,475. Most of the funds in larger IRAs originally are from company plan rollovers, not from annual contributions. The $1,245,475 cap does not include rollovers from company plans.

Rollovers from Company Plans

They don’t count! They are exempt from the bankruptcy estate. Any funds in an IRA that came from a company plan are protected from bankruptcy. There is no limit to this protection.

Example:
James has $6 million in his IRA (doesn’t everyone?). Let’s assume that $5.8 million is from funds he rolled over from his 401(k) and earnings on those funds and the remaining$200,000 is from annual IRA contributions and earnings on those contributions.

The $5.8 million is protected in bankruptcy under this law since these funds are from a company plan. They don’t count towards the $1 million cap because they are exempt in unlimited amounts. The other $200,000 is protected under the $1 million exemption, so all $6 million of IRA funds are protected under the bankruptcy law.

The Return of the Conduit IRA
It’s great that funds in IRAs that came from plan rollovers are exempt under the bankruptcy law in unlimited amounts, but how will you know how much of a client’sIRA balance is from plan rollovers? They better have great records and some way toshow how they calculated the amount of income attributable to the rollover funds. This would only be an issue for IRAs with over $1 million, since that amount would be protected even if none of it were from plan rollovers.

But if clients have, or expect to have, a large IRA (over $1,245,475), they’ll have to start keeping records and documentation, just in case they may need the bankruptcy protection.

Remember conduit IRAs? We also called them rollover IRAs. These were IRAs that contained only money rolled to an IRA from a company plan and earnings on those funds. But the 2001 Tax Act (Economic Growth and Tax Relief Reconciliation Act of 2001) contained provisions allowing all sorts of rollovers and plan portability so that for the most part you could commingle IRA contributions and rollovers from plans in the same IRA. Beginning in 2002 conduit IRAs were no longer necessary for most people rolling over plan funds (except for those who wanted to preserve the tax break for 10- year averaging). But now, because the bankruptcy law makes a distinction between IRA contributions (capped at $1,245,475 for bankruptcy protection) and rollovers from plans (unlimited bankruptcy protection) you may want to keep plan rollovers in a separate IRA like the old conduit IRAs.

If a conduit IRA is set up, it would pay to take the first withdrawals from other IRAs (the ones that contain only IRA contributions and earnings on those contributions) that are subject to the $1,245,475 cap. This way a client can reduce the amount of the IRA subject to the cap and secure the amount in the conduit IRA that is protected in total under the bankruptcy law.

SEP and Simple IRAs

They don’t count either! They are exempt the same as the plan rollovers above. This makes these accounts more attractive as retirement vehicles.

This law may encourage more people to fund their retirement accounts. Not only are they saving tax deferred for their retirement, but these funds may now be protected from creditors in bankruptcy. It is good to know that if you fall on hard times for whatever reason, for example a business fails and you have to declare bankruptcy, that at least the business retirement account is protected.

Solo Plans for Business Owners
If clients have a company plan (for example a Keogh or solo 401(k) plan) but have no employees other than the owner and spouse, they have no creditor protection under ERISA (Employee Retirement Income Security Act of 1974). But the bankruptcy law protects these accounts in bankruptcy. This will make the accounts much more attractive since they never had ERISA creditor protection but now will have unlimited bankruptcy protection.

Rollovers in Transit

IRAs and retirement accounts protected under the bankruptcy law are generally protected only as long as the funds remain in the retirement account. But some creditors might be waiting like a troll under the bridge for that moment that the funds are withdrawn to grab them as unprotected funds. Congress already thought of that and included a provision that would protect retirement funds in transit from one plan or IRA to another. If funds are withdrawn from an IRA, the law protects these funds while they are out of the IRA in transit to the new IRA or retirement account. The troll cannot grab them as unprotected funds.

Of course it is always best not to do a 60-day rollover where funds are withdrawn from one retirement account and deposited within 60 days to another. The preferred method isa trustee-to-trustee transfer (a direct transfer or what the IRS calls a “direct rollover”). Direct transfers are also protected in the bankruptcy law just in case a creditor tries to make a case that the funds were exposed for at least one second.

The law appears to protect eligible rollover distributions from company plans (not IRAs)even if these funds are not rolled over. If that is the case, then clients would have to be able to show that these funds came from a company retirement account. Of course certain distributions from plans such as required minimum distributions, 72(t) distributions and hardship distributions are not eligible rollover distributions so these funds would cease to be protected once withdrawn from the company plan or from an IRA.