Workplace defined-contribution plans and IRAs are vital for growing your money tax-deferred until you withdraw your savings at a later date. Hopefully, this is when all of your hard work pays off, while you’re laying on a beach somewhere, reaping the benefits of your tax-deferred savings plans and the strategic advice from your wealth managers.
Getting sued is just one of those life events that no one plans for. However, like divorce or the loss of a loved one, unfortunate events do happen, often with huge financial implications. The best way to deal with the prospect of a negative situation is to protect yourself from the potential pitfalls in advance.
Nothing makes a situation worse than a blindsided hit, where your assets can be taken from you along with the emotional burden of the circumstance at hand. For those late in their careers, a lawsuit could potentially wipe out their retirement savings. A survey by ICI Research Perspective showed that 63% of all U.S. households had retirement plans through work or IRAs, and 36% of U.S. households owned traditional IRAs and Roth IRAs in 2019. Much of the growth in IRA accounts results from employer-sponsored retirement plan rollovers.
Additional Benefits of Retirement Accounts
Retirement accounts have many additional benefits, apart from their well-known tax advantages. This is excellent news for the majority of Americans, as it turns out that one of the most effective ways to protect assets is to shield them in retirement accounts. Individual retirement accounts, 401(k)s, and other types of tax-efficient plans can help you prevent the loss of your assets in case of a lawsuit.
At the federal level, the rules are clear for 401(k) and employer-sponsored retirement accounts. State laws are more complicated when it comes to whether or not IRAs are fair game in case of a l awsuit.
The Retirement Plan Shield
First and foremost, make sure you do not owe any child support or taxes to the IRS since this will open up your accounts to lawsuits. Domestic relations lawsuits will lift IRA protections anywhere you reside within the country.
If you owe taxes to the IRS, your retirement assets may be fair game, just like any other asset that can be seized from you to settle the unpaid debt. The federal government will not change any rules associated with minimum withdrawal rules in case of a lawsuit and will charge a 10% early withdrawal rate if you are extracting money in reaction to your lawsuit.
In the event of a private creditor suing for unpaid debt, retirement accounts are usually protected, despite some exceptions to the rule. The Employee Retirement Income Security Act (ERISA) relates to federal protection of 401(k) and other employer-sponsored retirement accounts from creditors. The federal government ensures the safety of these accounts to protect retirement even in case of a lawsuit. Up to $1 million of a defendant’s IRA will be protected under the Bankruptcy Abuse Prevention Act of 2005.
However, in June of 2014, the U.S. Supreme Court decided that inherited IRAs will no longer be sheltered if the inheritor files for bankruptcy—except for any IRAs being inherited from a spouse.
Business owners, entrepreneurs, and other self-employed individuals should be aware of the issues that can arise in case of a lawsuit, which can damage not only the company but also their assets. To hedge against the risk of personal injury, business owners need to register as a limited liability company (LLC) or an S corporation.
If your field of work has a history of frequent lawsuits, it might be best to create an asset protection trust. Fields where this may be particularly beneficial are real estate, health, and the law itself.
According to Galfand Berger LLP, the average annual number of medical malpractice lawsuits filed each year was 85,000. Professional malpractice insurance can be relatively inexpensive and should be used to save professionals around the U.S. the stress of a wishy-washy consensus on IRAs.
Laws regarding retirement protection in the event of lawsuits vary state by state. Many states will not stop angry creditors from seizing your retirement and IRA accounts.
For example, California is a precarious state in which to own a retirement account if you are being sued or filing for bankruptcy. In California, IRAs are not as well protected as 401(k)s. What this means in practice is that if you are being sued for personal injury in California, your 401(k) will be protected from the prosecutor; however, your IRA will only be protected up to the point that the court deems necessary. The judgment will be based on a certain threshold that the court says will be sufficient to support you and your dependents in retirement. This should alarm those planning for retirement, as there is no specific threshold in place, and future events are far from predictable.
It is important to note that some states have limited or no laws protecting IRA savings in case of lawsuits. On the other hand, the best states for IRA protection in a lawsuit are Texas, Washington, and Arizona. In Arizona, only IRA contributions made within 120 days of the lawsuit are exposed to risk by the claimant.
Although there are established distinctions between states, it is crucial to understand that the law is never clear-cut. There may not be a straight answer for the outcome of your lawsuit, subject to the type of account (Roth IRA, traditional IRA, etc.) and local jurisdiction. For example, you may have greater protection of funds inside of your IRA account as opposed to those outside, even if they consist of distributions from the account.
Moran Knobel, a certified retirement plan consulting and administration firm, offers a comprehensive state-by-state list of laws protecting IRAs and provides an analysis of individual retirement accounts as exempt property.
Remember Your Umbrella
To those with assets tied to retirement plans and IRAs, acquiring an umbrella insurance policy (also known as a personal umbrella policy or personal liability umbrella policy) may help shield against the possibility of a creditor dipping into retirement accounts. Personal umbrella insurance can be added on top of your pre-existing homeowners insurance and auto insurance and will cover the excess cost in case of a catastrophe.
An attractive feature of an umbrella insurance policy during a lawsuit is that the insurance company is required to provide you legal defense on top of the coverage you already receive. It is important to note that umbrella policies do not cover business activities, intentional acts (such as sexual harassment), or punitive damages. In the case of a lawsuit, if you are required to pay out a claim, the umbrella insurance will come into play when your standard liability insurance has run out.
Umbrella insurance policies and professional malpractice insurance are two great ways to safeguard your IRAs. In this case, you can still receive the benefits of IRAs, which are more attractive due to the lower associated fees and investment flexibility in comparison to other employer-sponsored plans and 401(k)s.
The Bottom Line
It’s important to put in place basic safeguards to protect your retirement against lawsuits and bankruptcy. The federal government has laws in place to protect many retirement accounts, including 401(k) and employer-sponsored plans. When it comes to IRAs, states have a greater jurisdiction in deciding what is up for grabs in the case of a lawsuit.
If you are planning to retire or have many assets in retirement and IRA accounts, you may want to look into moving to a state with heavy protection of these accounts. To avoid kicking yourself later, make sure to be proactive in safeguarding your retirement—whether it be through malpractice insurance, umbrella insurance policies, or simply understanding the laws. As the laws are complex and often contain possible loopholes, it may be in your best interest to consult a legal professional.