Being sued can be a traumatic experience because it can create feelings of confusion, anger and fear. One might be consumed with worry, wondering if their assets, savings and retirement accounts are vulnerable to being lost. It's essential to understand how a lawsuit or bankruptcy could impact a 401(k) or an IRA.
Retirement Accounts: 401(k)
A 401(k) is a profit-sharing plan that lets qualified employees contribute part of their wages into individual accounts, and the IRS explains how they work in detail. The elective salary deferrals are deducted from the worker's taxable income. Employers have the option of contributing to these accounts and, while many do, others do not. The earnings and distributions from these accounts are included in the employee's taxable income when they retire.
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As a general rule, the Employee Retirement Income Security Act of 1974 (ERISA) protects certain retirement accounts from being seized by creditors like auto lenders. This includes 401(k) plans, some 403(b) plans and pension plans. There is no cap on these protected funds for most people, but other circumstances and regulations may apply. If you are found to be guilty of a crime and end up in prison, those funds could be garnished by the state to cover some of the prison's costs.
The writers at Forbes Advisor post that 401(k) retirement accounts are usually protected from liability lawsuits. These might include suits aimed at those who've caused a car accident, for example. If a creditor is the IRS or a former spouse, your 401(k) may not be entitled to protection under ERISA. An exception to this could be a valid prenuptial agreement that a married couple signed. The spouses would need to have specified that they would not share the 401(k) in the event of a separation or divorce.
Retirement Accounts: IRAs
An IRA (Individual Retirement Arrangement) lets you make tax-deferred investments through financial institutions, stockbrokers, mutual funds and life insurance companies, per the IRS. There are various kinds you can have on your own, including traditional and Roth IRAs, plus those set up through employers, such as SEP IRAs, Payroll Deduction IRAs and SIMPLE IRA plans.
IRAs do not have ERISA protection unless the account holder files bankruptcy. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) provides federal protection for IRAs up to $1 million. BAPCPA will not apply when account holders use IRAs for prohibited transactions. For instance, if you borrow from the IRA or pledge it as security for a loan, BAPCPA does not apply. Even though federal laws offer some protection, there may be state laws to contend with.
State laws, for instance, may establish scenarios under which retirement accounts are shielded from creditors and lawsuits. For example, Equifax claims that the first $1 million in an IRA in Michigan is protected, but if you have an inherited IRA, it won't be shielded.
Protecting Your Retirement Assets
People who try to hide their retirement assets from creditors and lawsuit proceedings may get away with it for a while, but they nearly always eventually get caught and will have to face the consequences. Instead of breaking the law, it is wiser to invest in insurance to protect your savings. This is where liability insurance comes in, and it is vital for anyone who drives a car or owns a home or business.
Liability insurance covers property damage, personal injury, bodily injury and defense costs for civil lawsuits filed against policy owners. Without this protection, one car crash could take away a liable driver's entire life savings. Another option is umbrella insurance, which goes over and above what traditional liability policies can provide. It is offered through home, auto and watercraft insurance providers and is recommended for people with significant assets vulnerable to lawsuits.
Consider also: Differences Between IRA & Non-IRA Accounts