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How Safe From Creditors is Your 401(k) Money if You Roll it to an IRA?

Wednesday, July 29, 2015

By Jeffrey Levine, IRA Technical Expert

“If I roll my 401(k) money to an IRA, how safe will it be from creditors?”
This is one of the most common – and in some cases, important – questions people have when they are considering moving their 401(k) money to an IRA. Unfortunately, there’s not just one simple answer.

In many ways, 401(k) funds typically represent the gold-standard of creditor protection. In most cases, your 401(k) funds qualify for creditor protection under a federal law known as ERISA (the most notable exception to this rule is if you are operating a solo 401(k) plan).  ERISA contains a special clause, known as the anti-alienation provision, which basically blocks your 401(k) money from the reach of most creditors. Typically, the only people who can get a piece of your 401(k) money while it’s inside of its protective “ERISA shell” are the IRS and an ex-spouse as part of a divorce proceeding. Other than that, your 401(k) creditor protection shield is virtually impenetrable.

What happens, however, if you move those ERISA-protected 401(k) funds to an IRA? Does the protection you had in your 401(k) follow along? Here’s where it can start to get a little complicated, because we actually have to split out your creditor protection into two distinct categories; creditor protection in bankruptcy and creditor protection in a non-bankruptcy event.

Let’s start with creditor protection in a bankruptcy, because it’s the easier of the two scenarios. Although bankruptcy laws are generally determined by each individual state, a 2005 federal law provides your retirement account with strong bankruptcy protection, no matter what state you live in. Under that law, plan funds, including 401(k) funds, are given an unlimited exemption in bankruptcy proceedings.  That means you can have $1 million in your 401(k), $5 million, $100 million... any amount, and all of it could be protected in a bankruptcy proceeding.

And here’s the part that’s even better. If you roll that money over to your IRA, the unlimited protection in bankruptcy proceedings will follow right along with it. So for instance, if things went really sour for you after you rolled your $100 million 401(k) over to an IRA – hello Mitt Romney, I’m talking to you! – then the entire $100 million would still be protected if you decided to file for bankruptcy.

Now let’s turn our attention towards the more complicated non-bankruptcy creditor protection scenarios. Briefly recall that while your retirement account money is held inside a 401(k), it generally has exceptionally strong creditor protection (in both bankruptcy and non-bankruptcy scenarios). However, while the unlimited bankruptcy protection those funds had inside the 401(k) follows them in a rollover to an IRA, the creditor protection in non-bankruptcy situations does not.

Instead, after your 401(k) funds are rolled over to an IRA, the non-bankruptcy creditor protection they’ll enjoy will be determined by your state’s laws. In some states, that protection will be roughly equivalent to the protection the funds had while they were in your 401(k). In other states, however, your protection could be much weaker. To complicate matters even further, some states actually provide traditional IRAs and Roth IRAs with different degrees of creditor protection!

So what does all of this mean? It all depends on where you live and how big of a concern creditor protection is to you. If you’re lucky enough to live in a state that offers strong protection to IRAs in non-bankruptcy situations (which, thankfully, is most states), then you’re probably not going to be giving up too much by rolling over your 401(k) to an IRA. If, on the other hand, you live in a state that does not offer a similar level of protection, you have to decide how important of an issue creditor protection is for you. If it’s not a concern and the benefits of an IRA rollover are more important to you, have at it! If, however, it’s a significant concern for you, then you might want to consider holding off on that rollover.