Many self directed IRA investors misunderstand or are unaware of the protections afforded to their IRA (Roth or traditional) as it relates to creditors and judgments. This article seeks to address the key areas of the law that every self directed IRA investor should know.
First, your IRA is not always exempt from creditors up to $1Million. Many IRA owners believe that federal law protects their IRA from creditors up to $1M. While Section 522(n) of the federal bankruptcy code protects an IRA owner’s IRA from creditors up to $1M, this protection is only provided to IRAs when an account owner is in bankruptcy. If the IRA owner is not in bankruptcy then the creditor protections are determined by state law and the laws of each state vary. For example, if you reside are a resident of Arizona then your IRA is still protected from creditors up to $1M even without filing bankruptcy. The approach Arizona takes is the most common, however, many states protections for IRAs outside of bankruptcy are extremely weak. For example, if you are a resident of California then your IRA is only protected in an amount necessary to provide for the debtor and their dependents. That’s a pretty subjective test in California and one that makes IRAs vulnerable to creditors. If your California IRA is from a rollover of a company plan, you may have other protections. California residents should check out my prior article here.
Second, while your IRA can be exempt from your personal creditors, as explained above, it is not exempt from liabilities that occur in the IRAs investments. For example, if your IRA owns a rental property and something happens on that rental property then the IRA is responsible for that liability (and possibly the IRA owner). As a result, many self directed IRA owner’s who won real estate or other liability producing assets utilize IRA/LLC’s which protect the IRA and the IRA owner from the liability of the property.
Third, if the IRA engages in a prohibited transaction under IRC Section 4975 then the IRA is no longer an IRA and is no longer exempt from creditors. Despite the bankruptcy and state law protections outlined in my first point above, if a creditor successfully proves that a prohibited transaction occurred within an IRA then account no longer is considered a valid IRA and therefore the protections from creditors vanish. There seems to have been an increase in creditors who are pursuing IRAs, particularly self directed IRAs, and I have been representing more and more self directed IRA owners in bankruptcy and other creditor collection actions in defending against prohibited transaction inquiries.
Fourth, many proponents of solo 401(k)s have argued that investors are better off using a self-directed solo 401(k) plan instead of a self-directed IRA because solo 401(k)s receive ERISA creditor protection (federal law) that is better than most state law creditor protections afforded to IRAs. While it is true that ERISA plan protection is better then state law IRA creditor protection and courts have already held that while a Solo K plan is a qualified plan it is not subject to ERISA. Yates v. Hendon, 541 U.S. at 20-21. Since a Solo K plan is not subject to ERISA, its account holders cannot seek ERISA creditor protection and would instead be treated the same as IRA owners. In sum, there is no difference in creditor protection between a solo 401(k) account and a self-directed IRA. We love Solo 401(k) plans, we just aren’t setting them up instead of IRAs because of asset protection purposes.
In summary, the best way to protect your self directed IRA from creditors is to understand the rules that govern your self directed IRA and to seek counsel and guidance to ensure that your retirement is available for you and not just your creditors.