Asset Protection & Your Pension Plan
ERISA generally makes it more attractive to retain funds in a qualified plan instead of converting the funds to a Roth IRA or traditional Roth IRA if the goal is to protect the assets.
What is actually protected and what isn't?
When one’s goal is asset protection, then the exclusion of qualified plan assets from the bankruptcy estate is generally protected under ERISA. The federal exclusion afforded ERISA plans, i.e. profit sharing, 401(k), will provide stronger protection than the exemption protection afforded IRA assets under The Bankruptcy Act. In addition, in non-bankruptcy situations, asset protection for IRA assets is based on uncertain and diverse state asset protection statutes. Therefore, leaving assets in a qualified plan provides superior asset protection.
In these economic times with a greater potential for bankruptcy or litigation, the increased asset protection afforded qualified plans warrants consideration of leaving the funds in the qualified plan during the beneficiary’s lifetime. At death, the beneficiary’s children could then execute a Roth IRA conversion.
Those filing for bankruptcy generally have two sources through which to protect their retirement plan assets from attachment. The debtor can either seek to claim an exclusion from the bankruptcy estate for the assets in the retirement plan, or they may ask for an exemption from the bankruptcy estate. Exclusion from the bankruptcy estate is the most favorable treatment an asset can receive. This is due to the fact that retirement assets qualifying for exclusion are never brought into the bankruptcy estate. Therefore, they are never subject to the claims of the creditors. An exemption, although less favorable, may also provide creditor protection. Assets which may be ineligible for exclusion, and are included in the bankruptcy estate, may nonetheless find protection from the creditors’ claims through an exemption.
The Employee Retirement Income Security Act of 1974 (“ERISA”) and the Bankruptcy Abuse, Prevention and Consumer Protection Act of 2005 (“The Bankruptcy Act”) are the two main bodies of federal law providing protection for retirement assets. The primary federal law under which retirement plan assets received exclusion is known as ERISA. ERISA virtually provides impenetrable protection for assets within covered employer retirement plans by excluding the plan assets from the bankruptcy estate. Since ERISA protection is not all encompassing, a retirement plan must fall under the scope of ERISA regulation in order to be afforded the protection.
401(k) and 403(b) plans, Defined Benefit plans, Money Purchase plans, and Profit Sharing plans are all afforded ERISA protection. You will note that traditional IRAs and Roth IRAs are absent from the list. Traditional IRAs and Roth IRAs are not covered by ERISA, and thus not excluded from the bankruptcy estate. These retirement plan assets are currently protected in the form of an exemption under The Bankruptcy Act.
The second body of federal law, The Bankruptcy Act, provides protection of retirement plan assets in a bankruptcy proceeding. Under The Bankruptcy Act, the form of protection is a specific exemption of retirement assets to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 417, 457, or 501(a) of the Internal Revenue Code of 1986. Even though ERISA provides protection for the covered retirement assets, the provision of The Bankruptcy Act generally now controls on the issue of creditor protection for both ERISA and non-ERISA retirement plans.
All IRA accounts, regardless of state bankruptcy laws, are now afforded creditor protection through The Bankruptcy Act. Unlimited exemption protection is provided for rollover IRAs. Contributory IRA is limited to protection of a $1,000,000 exemption. It is best not to rollover qualified plan accounts into contributory IRAs, because the unlimited protection would be lost and the $1,000,000 limitation would be all that is available. Instead of rolling qualified plans into a contributory IRA, it would be best to roll them into a new IRA set up specifically for receiving the rollover funds.
ERISA will generally apply consistently between bankruptcy and non-bankruptcy situations. Non-ERISA retirement plan assets in non-bankruptcy situations will be dependent on state law. This is due to The Bankruptcy Act which generally only applies to debtors who have filed for bankruptcy. Therefore, those in non-bankruptcy situations must consult their state asset protection laws to determine the protection of their IRA assets.
As you can see, the decision to rollover qualified retirement funds into a Roth or traditional IRA does not hinge purely on tax or financial planning considerations, but legal implications involving creditor protection must be considered as well. In general, it is clear that due to the exclusion afforded ERISA plans, the asset protection is stronger than the protection afforded rolled over IRA assets. As can be seen, non-ERISA plan assets, although provided exemption under The Bankruptcy Act must rely on the uncertainty of IRA protection under their state asset protection laws in non-bankruptcy situations. This does not occur if the assets remain in a qualified plan as they are protected under ERISA’s exclusion in both bankruptcy situations and largely in non-bankruptcy situations.
Caution must be exercised before executing a Roth conversion as the asset protection needs of the individual must be determined and incorporated into the Roth IRA conversion analysis. The income tax benefits, which might be achieved through Roth IRA conversion, may not out weigh the asset protection risks.