Retirement accounts at ‘serious risk’ as COVID-19 spurs bankruptcies
If there’s one thing clients have always relied on in troubled times, it’s that last bastion of savings, the retirement account — whether it be a 401(k) or an IRA.
But we’re now into the ninth month since COVID-19 hit our shores and nothing can be taken for granted. Business closures, bankruptcies and lawsuits from creditors have soared, calling into question even that formerly unassailable bulwark. That’s why it’s crucial that advisors know which accounts can be protected in bankruptcy and in non-bankruptcy lawsuits — and which cannot.
Make no mistake: Not all possess the same safeguards. Retirement accounts carry a number of different protections. These layers of defense shield IRA owners and company plan participants from bankruptcy and general (non-bankruptcy) creditors. In addition, levels of protection vary widely from state to state. In the current environment with so many small businesses on the brink of closing and struggling employees in limbo, increased bankruptcy filings are placing retirement savings at serious risk, especially when these might be the only funds available for a personal bailout.
That’s why it is imperative to understand which accounts hold what protections, and how retirement assets are shielded from those anxious to get a piece of their nest egg.
ERISA plans: The gold standard
Most employer-sponsored retirement plans, such as 401(k)s, fall under the Employee Retirement Income Security Act of 1974 guidelines and receive creditor protection at the federal level. ERISA offers the gold standard of protection up to an unlimited amount against both bankruptcy and non-bankruptcy general creditor claims.
To illustrate, let’s take the hypothetical example of “Mark,” a successful contractor who flips houses. He has a 401(k) plan set up for himself and the employees of his sole proprietorship. Mark’s current plan balance is $1,500,000.
Recently, however, there was an accident at one of his construction sites, and Mark is being sued personally. Even if Mark loses the lawsuit, the assets in his 401(k) remain protected by ERISA up to an unlimited amount. Additionally, if Mark were to declare bankruptcy, his 401(k) would be off limits to bankruptcy creditors.
Going solo = greater exposure
The same protections do not, however, hold for solo 401(k) plans.
Often, business owners worried about potential lawsuits keep their retirement funds in their so-called solo-K because they believe it to be fully creditor proof, as opposed to an IRA.
Butsolo 401(k) plans are not covered by ERISAand have no creditor (non-bankruptcy) protection under that law. Plan balances will only receive non-bankruptcy creditor protection available under applicable state law.
These plans do, however, receive full bankruptcy protection under the bankruptcy code. This is also the case with other non-ERISA company plans such as SEP and SIMPLE IRAs, non-ERISA 403(b) plans and 457(b) governmental plans.
Bankruptcy and IRAs
Traditional and Roth IRA contributions and earnings are protected from bankruptcy under federal law up to an inflation-adjusted cap — currently $1,362,800.
Is this a sufficient limit?
If the maximum amount was contributed to an IRA each year from 1975 to 2020, there would be $141,500 in contributions — $158,500 if the IRA owner qualified for age 50 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 over $1,362,800.
But what about rollovers from plans to IRAs? Do these dollars count against the $1,362,800 cap?
They do not. Former company plan assets (previously protected by ERISA while in the plan) rolled to an IRA will obtain unlimited bankruptcy protection under the bankruptcy code. As an added bonus, rollovers from SEP and SIMPLE plans also do not count against the $1,362,800 cap.
As an example, let’s conjure up “Sheila,” an attorney with a $2,000,000 balance in her company’s ERISA 401(k) plan and a $700,000 balance in her IRA, which is composed entirely of contributions and earnings.
In April, Sheila retired from her law firm and in May rolled her 401(k) into her IRA. Sheila’s IRA is completely shielded from bankruptcy. The bankruptcy code protects her $2 million 401(k) rollover up to an unlimited amount, and the $1,362,800 cap is enough to cover her original IRA balance.
Note that in this example, Sheila did not need to keep her 401(k) and IRA dollars separate to retain the maximum bankruptcy protections. However, from an administrative standpoint, it could make sense for some individuals to keep rollover assets separate via a conduit IRA to avoid confusion.
Lawsuits and IRAs (non-bankruptcy)
General creditor protection (e.g., when a person wins a judgment in court against the account owner) for IRAs, Roth IRAs and IRA-based company plans like SEPs and SIMPLEs is based on individual state law — and these state-level, non-bankruptcy protections vary widely.
As such, it is important to understand your client’s state coverage, especially before advising the client to roll over ERISA plan dollars into an IRA.
As mentioned, ERISA-covered plans enjoy full bankruptcy and general creditor protection. While all former plan dollars remain protected in bankruptcy by the bankruptcy code after a rollover to an IRA, these same dollars do not retain unlimited general creditor (non-bankruptcy) protection. Assets rolled from an ERISA plan to an IRA will now fall under the applicable state-level protections. These state safeguards may be comparable to ERISA levels, or they may be significantly less so.
For instance, the hypothetical“Dr. Kapp” changed employers and is deciding what to do with his $400,000 401(k) plan. His profession exposes him to malpractice lawsuits. If Dr. Kapp rolls the assets from his work plan to an IRA, the $400,000 will be fully protected in bankruptcy. However, he will be limited to the general creditor (non-bankruptcy) protections offered under state law.
Instead, Dr. Kapp elects to roll his former plan assets into the 401(k) plan offered by his new employer. That way, he ensures the $400,000 will retain 100% ERISA protection from both bankruptcy claims and any malpractice judgments against him.
Inherited IRAs and bankruptcy
In a landmark decision released in 2014, Clark v. Rameker, the U.S. Supreme Court ruled unanimously that inherited IRAs are not protected in bankruptcy under federal law.
Since only "retirement funds" are protected under the bankruptcy code, the primary issue before the court was whether an inherited IRA is, in fact, a retirement account. The Supreme Court decided that inherited IRAs do not contain “retirement funds” because:
1. Beneficiaries cannot add money to inherited IRAs;
2. Beneficiaries of inherited IRAs must generally begin to take RMDs, regardless of how far away they are from retirement; and
3. Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a 10% early distribution penalty.
As a result, the favorable bankruptcy protection afforded to such funds under the bankruptcy code does not extend to inherited RIAs.
Bankruptcy timing and rollovers in transit
IRAs and retirement accounts protected under the bankruptcy law are generally shielded only as long as the funds remain qualified. Creditors will sit patiently until retirement dollars are withdrawn to snatch them as unprotected assets.
However, these funds remain safeguardedas long as they are qualified dollars. If funds are withdrawn, the law protects these dollars while they are out of the IRA in transit to the new IRA or retirement account. This protection applies to 60-day rollovers as well as trustee-to-trustee transfers. An individual only receives this protection if bankruptcy paperwork was officially filed while the funds were still in the retirement account. Timing is key in such cases. Funds already out on rollover when bankruptcy is declared lose all protection.
IRAs and the LLC shield
IRAs enjoy specific levels of protection against “outside” claims, i.e., claims brought personally against the IRA owner.
But what happens when a claim is brought against an investment within the IRA? The answer is that such “inside” claims may not only devastate the IRA but could also put an IRA owner’s personal non-qualified assets at risk. Inside claims can be mitigated with the use of a limited liability company (LLC).
The imaginary “Blake” owns a self-directed IRA worth $500,000 that invests entirely in a local Jet Ski rental and watersports company. He did not use an LLC within the IRA to acquire the rental business. Blake has other personal assets worth $1.5 million.
Last summer, a Jet Ski renter had an accident and suffered a catastrophic injury. After almost a year of litigation, the renter won a $2 million judgment against the IRA.
All of Blake’s IRA assets could be reached because the claim arose from activities of the IRA investment. His personal assets could also be at risk. But if Blake’s IRA had been invested in an LLC that subsequently purchased the water sports company within the IRA, the LLC structure would have protected both the IRA assets and Blake’s personal assets against the $2 million judgment.
Be keenly aware of outside vs. inside claims and how to mitigate certain risks with an LLC.
Clear and present danger
Add the ongoing COVID-19 outbreak to our litigious society with the increasingly looming possibility of bankruptcies, all under the watchful eye of SEC Reg BI, and educating clients on available safeguards becomes increasingly vital.
That education holds even more true for financial advisors in whom clients have placed their trust and financial futures. Understanding the levels of bankruptcy and non-bankruptcy protections afforded to both workplace retirement plans and IRAs is now a must to safeguard the dreams of post-work life clients have worked so hard to achieve.