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Pending bankruptcy legislation would protect IRAs

IRA protection No matter what side of the fence you're on when it comes to the pending Bankruptcy Reform Act legislation, one major benefit that's likely to come from its passage is protection -- to some extent -- for IRAs from creditors should you file for bankruptcy.

ERISA -- Employee Retirement Income Security Act -- is the federal law that protects 401(k) and pension plans from creditors in most cases. Exceptions include a federal tax lien against you or if a former spouse is entitled to some of your benefits.

But IRA protection is left up to the states -- and it's a mishmash of laws. Most states safeguard traditional IRAs, but many don't afford the same protection to Roth IRAs.

That means if you file for bankruptcy before the federal law passes, your IRA or Roth retirement fund could be grabbed by creditors, depending on the state where you live. Yet, some states will safeguard your horse and buggy from creditors.

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"States for some reason have been very lax about updating property exemptions," according to Todd Zywicki, law professor and bankruptcy expert at George Mason University in Arlington, Va. "California is one that regularly updates its list of property that's exempt, but a lot of states don't.

"You'd think New York would be very progressive, yet it still has turn of the century exemption rules -- all stoves with the necessary fuel for 60 days, one sewing machine. Clearly, protecting IRAs should be a state policy."

Professor Charles Tabb, bankruptcy expert at the University of Illinois College of Law in Champaign, Ill., says it's always been a bit curious to him that the states have been in charge of deciding whether IRAs are exempt from bankruptcy.

"The ability to make an entitlement, such as an IRA, is federal law. It's odd that Congress gives that right to people and then punts back to the states. There's been a lot of litigation on whether it's even a legitimate thing for Congress to allow the states to make the call when IRAs are controlled under federal law."

Pending protection reforms
The Bankruptcy Reform Act -- in its current reincarnation -- would protect up to $1 million in IRAs, including Roths, from creditors.

"You would think that protecting retirement accounts would be very compelling public policy," says Zywicki. "It's consistent with the trend to encourage private savings; especially since the states aren't acting in a uniform manner."

Bankruptcy attorney James Caher of Eugene, Ore., dislikes many of the provisions in the Bankruptcy Reform Act, but says the IRA protection is good.

"It's just good policy that older Americans should have some sort of retirement plan and a place to live. Unless you have clear issues of fraud or abuse -- borrowing a bunch of money and trying to protect it in a retirement plan. Going after pensions and homesteads is how the credit industry thinks it will get bailed out of this foolish lending they've done."

Caher says a blanket federal law protecting IRAs is needed and until protection was established under Oregon law, he advised against clients setting up a Roth IRA, which has the least protection of all IRAs other than Education IRAs.

"Until the legislation fixed this, I was warning people not to do Roth IRAs. If bankruptcy is in your future, don't do a rollover or take a distribution without talking to a bankruptcy lawyer."

Millions of Americans have set up rollover IRAs and Roths without giving a second thought about whether they'd be shielded from creditors. Most people assume they'll never file for bankruptcy, and if they do, they probably think their retirement accounts are safe.

Unless we have assets that are significantly higher than our debts, any of us could find ourselves quickly overwhelmed by bills if we lost our jobs or got wiped out by divorce or medical bills. Couple that with the fact that many people are pumping money into Roths for its tax benefits and you have a financial disaster if your state doesn't protect Roths or regular IRAs.

Experts say many states seem hesitant to exempt Roths because federal law protects deductible contributions, and Roth contributions are nondeductible. Another often-debated issue is whether protection should be afforded to IRAs that aren't employer-sponsored. Employer-sponsored IRAs are the SEP IRA and the Simple IRA.

State protection?
State laws regarding IRA protection are so varied and change so rapidly that the best way to find out how you're protected is to check with a bankruptcy attorney or your state legislature. Be very specific about the type of IRA you have -- traditional, rollover, Roth, etc.

But even in states that do protect IRAs, statutory exemptions don't always keep creditors from going after IRAs. There are numerous cases where creditors try to claim that a particular debtor's IRA isn't covered by the statutory exemption for various reasons.

A blanket federal law would likely correct all of that.

Zywicki says the current version of the Reform bill would not allow money borrowed against a retirement plan to be deductible in a bankruptcy.

"Right now you can borrow against your retirement savings and discharge that loan in bankruptcy court, as long as there was no fraudulent attempt when you took out the loan," says Zywicki.

The new bill protects money put into an Education IRA at least one year before filing for bankruptcy. Zywicki says there are no similar restrictions for Roths or regular IRAs.

The Bankruptcy Reform Act is being spiffed up in a House-Senate conference committee. Zywicki says both versions are pretty similar, and he expects it to pass by the end of the year.

-- Posted: Aug. 29, 2001

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