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October 2001
Vol. 10, No. 10, pp 53–54.
Personal Business
Shielding your IRA from bankruptcy

Also: IRS allows disability policy in 401(k) plan

opening artThe treatment of individual retirement accounts—Roth, SEP, SIMPLE, and Education IRAs—in bankruptcy varies considerably under state law. Although federal laws prohibit creditors from touching retirement money in employer-sponsored plans, a patchwork of state laws controls IRAs. All IRAs (whether tax-deductible, non deductible, or Roth) are retirement assets and should be afforded the same protection as other retirement assets, such as 401(k) plan contributions, when an individual files for personal bankruptcy protection. But they’re not.

Dissimilar treatment of retirement assets under state bankruptcy laws can lead to inconsistent and unfair results. For example, under current law, an individual who rolls over retirement assets from a 401(k) plan to an IRA loses the asset protection that he/she would have if the money were left in the 401(k) plan. During the past few years, many state legislatures have acted to address this inequitable treatment and have been expanding protection of IRA money.

To understand why IRAs are often accessible to the reach of creditors, go back to 1974, when Congress passed two laws: Section 408 of the IRS tax code, which created IRAs, and the Employee Retirement Income Security Act (ERISA).

ERISA initially was established to protect defined-benefit programs (such as pensions) and other employee benefits. With the inception of 401(k) plans in the early 1980s, ERISA was extended to cover them as well, setting standards for eligibility, performance, investment selection, funding, and vesting. Employers with these plans are required to hold the assets in a special custodial account, apart from corporate assets. If an employer declares bankruptcy, creditors can’t touch the assets of the plan. By default, these protections also cover workers. IRAs, on the other hand, aren’t covered by ERISA because they’re not part of an employer-sponsored plan. As a result, IRAs are considered personal property, so state personal property laws cover them. During the past 15 years, states have been strengthening their bankruptcy and personal property laws so that IRAs can be shielded from creditors.

An increasing number of states are excluding IRAs from the assets creditors can seize in the event of personal bankruptcy. There are several reasons for this change. The first is that IRAs often are the only available depository for holding money from federally protected plans (such as 401(k)s) while workers are between jobs or waiting to be eligible to enroll in a new employer’s plan. As a result, there’s an implied assumption that money held in these depository IRAs will eventually be placed in a federally protected plan.

Another realization is that IRAs commonly are used to hold the bulk of one’s retirement savings. If a worker’s retirement assets are wiped out in bankruptcy court, that worker may wind up on the welfare rolls of that state. With the emergence of two relatively new types of IRAs, Education and Roth, many states are again revising their laws to extend their protections.

Compiling a definitive list of IRA protections offered by each state is difficult because the laws keep changing. Every two years, the Investment Company Institute (ICI), the trade association for the mutual fund industry, surveys state bankruptcy protection laws and publishes a brief report. Although the most recent ICI report is for the end of 1999, it’s a good starting point. Check with a local attorney who specializes in bankruptcy, taxes, or benefits for the laws that apply in your state if you want to know what amount of protection exists for your IRA money.

According to the ICI survey, states offering the strongest bankruptcy protection include Connecticut, New Jersey, Ohio, and Washington. As of the end of 1999, those states’ bankruptcy laws protected IRAs, Roth IRAs, Education IRAs, SEP-IRAs, and SIMPLE IRA plans. States appearing to offer some of the weakest protection and most ambiguous laws include Alabama, the District of Columbia, Georgia, Hawaii, Indiana, Iowa, Mississippi, Nevada, New Hampshire, New Mexico, Oklahoma, Pennsylvania, South Dakota, Tennessee, and Wyoming.

Providing uniform bankruptcy treatment of all retirement assets would lessen confusion on the part of Americans if they find themselves in the unfortunate situation of having to file for bankruptcy protection. IRAs encourage Americans to save for their retirement and often serve as a repository for 401(k) and other retirement plan moneys that were afforded bankruptcy protection by ERISA.

IRS Allows Disability Policy in 401(k) Plan
A recent IRS ruling permits employers to offer a disability income feature as part of a 401(k) plan. This adds a new and valuable investment option that progressive employers can offer employees.

In its ruling, the IRS said that the purchase of a long-term disability insurance policy within a 401(k) plan did not violate any provisions of the tax law. The IRS also said that the employer or employees who elected such coverage would not lose any of the tax-favored treatment of plan contributions used for premiums on the policy.

Like most 401(k) plans, this plan provided for pretax salary contributions by employees and an employer match. What the employer wanted to do was come up with a way to guarantee that an employee’s retirement savings accumulation would continue even if the employee became disabled. The employer offered employees the option of using a portion of their 401(k) contribution to purchase a long-term disability insurance policy. The way the policy worked, each employee who participated in the disability insurance coverage told the 401(k) plan trustee to allocate a portion of his or her salary deferrals for the purchase of the disability insurance policy. The plan, not individual employees, purchased the insurance policy. The premiums were paid monthly.

If a plan participant became disabled, the policy would pay monthly benefits to the plan (not the employee) in an amount equal to one-twelfth of the plan participant’s contributions plus the employer’s matching contributions that were made to the plan in the year preceding disability. The plan would treat any policy payments as investment earnings, which would be allocated to the account of the plan participant who purchased the disability insurance coverage. In other words, disabled employees could continue to accumulate assets in their 401(k) plan as if they had remained working. Disabled employees who were having payments made to their account by the insurance company would be able to direct the investment of these amounts just as if they were still on the job.

The policy required a one-year elimination period to make sure that it didn’t attract a disproportionate number of employees in poor health. Under the plan, benefits would continue until the employee’s death, recovery from disability, withdrawal by the employee of account proceeds attributable to the disability insurance proceeds, termination of the plan, or a maximum payment period that was based on the employee’s age at the onset of disability and was stipulated in the policy at the onset of coverage.

The employer asked for and obtained three specific rulings from the IRS:

  • Participants who elect the disability insurance coverage will not be taxed on the cost of the coverage. The IRS said that the payment of premiums constituted an incidental benefit, so plan participants who elected coverage would not be taxed on the cost of the disability insurance, that is, the monthly premium.
  • Amounts paid under the disability insurance policy will not be taxable to plan participants when paid to the plan. The IRS noted that any amounts paid under the policy would be considered plan earnings, not employee earnings. No direct payments were made from the policy proceeds directly to any plan participant, so no taxable event occurred at the time the proceeds were paid to the plan.
  • The purchase of the coverage will not violate the “contingent benefit” rule for 401(k) plans. This rule says that a 401(k) plan cannot make benefits (other than the employer match) contingent, either directly or indirectly, on the employee’s decision to participate in the plan. The IRS had no problem with this request, noting that existing regulations make it clear that a 401(k) plan can purchase life insurance with a participant’s contributions without violating this rule, so why should a disability insurance plan be treated differently? The IRS said that if it’s okay for a 401(k) plan to purchase life insurance, it should be okay to purchase disability insurance. In addition, the IRS noted that a 401(k) plan is just another type of employee benefit plan, and disability benefits provided to employees through an employer plan are not taxable to employees.

Milton Zall is a freelance writer who specializes in taxes, investments, and business issues. He is a certified internal auditor and a registered investment adviser. Send your comments or questions regarding this article to tcaw@acs.org or the Editorial Office 1155 16th St., N.W., Washington, DC 20036.

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