What Is IRA Bankruptcy Protection?

Definition & Examples of IRA Bankruptcy Protection

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IRA bankruptcy protection is a provision made by Congress that allows individual retirement account owners to protect their individual retirement accounts (IRAs) from creditors in a bankruptcy proceeding. Whether you have a traditional IRA or a Roth IRA, the federal government extends significant protection from creditors—within limits—in the event you declare bankruptcy.

If you think that personal bankruptcy is a real possibility in your future, understanding IRA bankruptcy protection can potentially save a significant portion of your net worth, as well as unnecessary taxation from premature distributions. Learn more about what's covered—and what isn't—under IRA bankruptcy protection.

What Is IRA Bankruptcy Protection?

IRA bankruptcy protection was signed into law by President George W. Bush under the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The act took steps to insulate retirement funds from creditors by providing that contributions to various retirement plans are excluded from "property of the estate." 

The passage of BAPCPA enabled for the first time protection for individual retirement accounts, including traditional IRAs, Roth IRAs, and certain other individual retirement accounts. Prior to the 2005 act, the only qualified retirement plans that received bankruptcy protection were 401(k) plans, pensions, and similar employer-sponsored retirement plans. Initial protection provided by BAPCPA was limited to a maximum of $1 million.

How IRA Bankruptcy Protection Works

IRA bankruptcy protection covers all of the conventional individual retirement accounts, including traditional IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs, and rollover IRAs. In some cases, protection extends up to a certain dollar amount, which typically increases on a periodic basis.

Here is a summary of IRA bankruptcy protection, according to BAPCPA, based on the type of IRA:

  • Traditional IRAs and Roth IRAs: Historically, the limits on bankruptcy protection for IRAs have been adjusted every three years. The most recent adjustment was in 2019 when the limit was raised to $1,362,800.
  • SEP IRAs and SIMPLE IRAs: These IRAs are designed for self-employed individuals and small businesses. They receive the same protection as traditional IRAs and Roth IRAs, but up to an unlimited amount.
  • Rollover IRAs: BAPCPA identifies rollover IRAs as a traditional IRA or Roth IRA that was originally funded by a rollover transfer from an employer-sponsored retirement plan such as a traditional 401(k) or Roth 401(k). Like SEP and SIMPLE IRAs, protection on these accounts is not capped.

The above limitations are extensive enough to cover the vast majority of IRA account holders because they cover every conventional type of IRA and the account balance maximums are higher than is ever attained by most IRA investors.

The cap on protection for traditional and Roth IRA accounts apples to the sum of all such accounts, not to each individual account.

What's Not Covered in IRA Bankruptcy Protection

IRA bankruptcy protection is quite extensive, but some creditors can still claim assets in your IRA. Some examples of what's not covered in IRA bankruptcy protection include judgment creditors, IRS levies, and divorce:

Judgment Creditors

Generally, there is no federal protection for IRA owners, and the protection from judgment creditors varies by state law. Therefore, it is possible that judgment creditors can claim IRA assets, depending upon the state.

IRA Assets and IRS Levy

If you owe past taxes to the Internal Revenue Service, it can put a levy on your pay and your IRA. Generally, the IRS will put a levy on other assets before your IRA, but your retirement account assets are not off-limits to the IRS.

IRA Assets and Divorce

IRA assets are not protected from divorce, but that doesn't mean separating IRA assets is absolutely necessary. What happens to your IRA assets in a divorce depends upon a court order and other assets that you hold.

For example, if your shared assets are $100,000, and your IRA assets comprise $20,000 of that, both sides can agree where those assets come from (e.g., IRA assets remain with one divorcee, and other assets get distributed instead). Fortunately, if IRA assets are divided, taxes can be avoided. According to the "incident to divorce" rules in the tax code, IRA assets can be transferred and split between spouses without taxation.

When it comes to IRA bankruptcy protection, each case is unique. As with all matters that are related to legal questions, IRA owners should seek legal counsel to confirm what may happen with their IRA in their unique situation.

Key Takeaways

  • IRA bankruptcy protection is a federal law that protects your individual retirement accounts (IRAs) from creditors in the event of a bankruptcy.
  • Roth and traditional IRAs are protected up to a certain limit, which changes every three years, while other accounts such as SEP and SIMPLE IRAs have no cap.
  • There are still certain cases, such as divorce or back taxes, in which your IRA may not be protected in bankruptcy.