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Qualifed Retirement Plans: Safe From Creditors, but Not Necessarily From Others

Deferred income tax and employer contributions aren’t the only good things about qualified retirement plans such as 401(k)s. Another advantage is that plan funds enjoy protection from creditors. In other words, the people to whom you owe money -- as a result of normal debt, bankruptcy or a civil court judgment -- may not reach your retirement funds to satisfy the debt. On the other hand, divorce court and tax court judgments are a different matter because qualified retirement plans aren’t federally protected from divorce settlements or federal tax liens.

However, nonqualified retirement plans, such as IRAs, don’t enjoy the same federal protection as qualified plans. Whether your IRA is protected from creditors depends on your state’s law. Let’s review the rules that cover retirement plans and creditor protection levels.

Most private employer-sponsored retirement plans are regulated by the federal Employee Retirement Income Security Act of 1974 (ERISA). In addition to 401(k) plans, qualified plans subject to ERISA include 403(b)s, savings incentive match plans for employees (SIMPLEs), profit-sharing plans and defined benefit plans. ERISA features an “anti-alienation” provision that essentially bars employers from allowing creditors to garnish or seize employees’ retirement funds while the employer still possesses them. If the employer violates the rule, its retirement plan will permanently lose its tax advantages.

Once the funds are distributed as retirement benefits, they’re no longer in the employer’s possession and therefore don’t enjoy the same protection from creditors. To ensure the anti-alienation provision covers your retirement plan, check to make sure your plan document features its own anti-alienation clause. Also bear in mind that there are two main exceptions to ERISA’s anti-alienation provision:

1. Divorce action. According to a 1984 federal law, when one spouse claims part of the other spouse’s retirement plan to satisfy his or her alimony or child support obligations or to secure his or her property interest in those benefits, the state court may issue a qualified domestic relations order (QDRO) allowing the first spouse access to plan assets.

2. Federal tax lien. If you owe the IRS money and it obtains a tax lien, the government can seize some of your retirement benefits. However, qualified retirement funds are even protected from state tax liens.

Retirement Plans Not Covered

ERISA doesn’t cover nonqualified retirement plans, which include IRAs, Simplified Employee Pensions, “employee welfare” plans (such as deferred compensation plans and salary continuation plans) and plans that cover only one employee plus his or her spouse. Therefore, nonqualified plans are not protected by ERISA’s anti-alienation rule. That means the plan funds may be vulnerable not only to the employee’s personal creditors, but also to the sponsoring employer.

Many states have enacted laws that protect to some extent non-ERISA retirement plans from creditors. In some cases, the state will protect only the amounts needed by a retiree for reasonable support and care.

A person who intends to file for bankruptcy may be tempted to contribute as much money as possible to a 401(k) or other qualified retirement plan, in order to protect it from creditors. A bankruptcy court may, however, consider the contribution to be fraudulent, meaning it was made primarily for the purpose of impeding a creditor’s rights.

Generally, if you make contributions to a retirement plan on a regular basis, and continue to do so before entering into bankruptcy, such contributions should not be considered fraudulent. But the court will probably look at any “pre-filing” contribution as suspicious. If the contribution’s timing doesn’t fit your regular pattern, a bankruptcy court may consider it a fraudulent conveyance and allow a creditor to attach the funds.

Even without protection from creditors, contributing regularly to a retirement plan is an important element of your personal wealth-building strategy because of its tremendous tax advantages. The fact that such plans offer a safe haven from creditors makes them all the more important. We can help you review the protections offered by your retirement plan, and possibly adjust your strategy to gain greater benefit.

Protecting assets from creditors isn’t the only reason -- and in most cases it’s not the primary advantage -- of contributing part of your salary to a qualified retirement plan. The main advantage is the substantial income tax savings you can achieve.

Employees who contribute pretax dollars to their qualified retirement plan save twice: first by not having to pay income tax on the portion of their salary that goes directly into the plan; and second because growth on retirement account assets (assuming they appreciate in value) is tax-deferred. After you retire and start taking distributions from the retirement account, you’ll pay income tax on it, but chances are you’ll be in a lower tax bracket than when you contributed to the account. And growth of tax-deferred savings can be phenomenal.

IRAs are not regulated by ERISA, so they’re not considered qualified retirement plans. But they offer excellent tax benefits as well. In a traditional IRA, individual contributions of up to $3,000 (for people who meet the adjusted gross income requirements) are deductible and growth is tax-deferred. Even nondeductible contributions will yield tax-deferred growth. In addition, individuals who are age 50 or older may make an additional $500 catch-up contribution each year through 2005.

In a Roth IRA, contributions are not deductible but growth is tax-free.

Please contact our office for additional information.