By J.P. Dahdah, Founder & CEO of Vantage IRA
When it comes to your finances, how safe are your retirement savings?
Most investors respond to this question based solely on the overall investment risk profile they attach to each asset in their retirement portfolio. But this type of analysis leaves their nest egg exposed to various other risk factors.
Unfortunately, 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 legal judgments. This article seeks to address four key areas of the law that Self-Directed IRA investors should be aware of to ensure their retirement assets are adequately safeguarded.
1. Your IRA is not always exempt from creditors up to $1 million.
A common belief among IRA owners is 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, which varies from state to state.
As a resident of Arizona, your IRA is protected from creditors up to $1M, even without filing bankruptcy. The approach Arizona takes is the most common; however, several states’ protections for IRAs outside of bankruptcy are extremely weak. As a resident of California, for example, your IRA is only protected to 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 you live in California and your IRA is from a rollover of a former employer’s plan, you may have other protections which you should seek to understand in greater detail.
2. Your IRA is not exempt from liabilities that occur within the assets held in your IRA.
Assets held within your IRA do not receive blanket protection. For example, if your IRA owns a rental property and something happens on that rental property, then your IRA — and possibly you as the IRA owner — is responsible for that liability. As a result, some Self-Directed IRA owners who own real estate or other potential liability-producing assets utilize entities like limited liability companies (LLCs). LLCs protect the IRA and the IRA owner from the liability of the property.
3. Prohibited transactions that occur within an IRA remove IRA status.
If a Self-Directed 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 the first point above, if a creditor successfully proves that a prohibited transaction occurred within an IRA, then the account no longer is considered a valid IRA. Therefore, the protections from creditors vanish. There has been an increase in creditors who are pursuing IRAs, particularly Self-Directed IRAs, since they are used to make investments in the private markets.
4. There is no difference in creditor protection between a Solo 401(k) account and a Self-Directed IRA.
Proponents of Solo 401(k)s sometimes argue that investors are better off using a Self-Directed Solo 401(k) plan instead of a Self-Directed IRA. This is 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 1) ERISA plan protection is better than state law IRA creditor protection, and 2) courts have already held that a Solo 401(k) plan is a qualified plan that is not subject to ERISA rules, its account holders cannot seek ERISA creditor protection and would instead be treated the same as IRA owners. As a result, creditor protection between a Solo 401(k) account and a Self-Directed IRA are the same.
Make sure your retirement savings are as safe as you think they are.
My hope is that after reading this article, your retirement savings are safer today. Remember, knowledge isn’t power unless you act on what you’ve learned. As you reflect on what you can do next to align your asset protection strategy to your alternative investment strategy, make sure you feel confident that your retirement will be available for YOU in the future and not in the hands of any creditors.
Happy investing!