Q.  My wife and I have a lot of credit card debt and we are having difficulty keeping it current. Most of  our savings is in my IRA. Are these funds protected from our creditors? 

A.  In California, Traditional IRA accounts enjoy only limited protection under state law, but expanded protection under federal bankruptcy law. Here is the way it works: 

Traditional IRA:  State law extends limited protection to funds held in Traditional IRA accounts, including ROTH IRA’s. This protection is based upon the extent that you can demonstrate to a judge that you need the funds to provide support for yourself and your dependents. If you were sued by a creditor, the matter would end up in court and a judge would decide the extent of any protection, typically based upon the following criteria:   (1) do you need the IRA funds for support and, if so, how much?, and (2) will you be able to replenish those retirement funds if they are awarded to the creditor.  Thus, if you rely upon the IRA for support, and if you are retired and not able to return to employment to earn back the funds, a judge might be inclined to allocate more of the IRA pie to you than to your judgment creditor. However, the extent of protection would be up to a judge, and so there is no assurance as to how much would be protected in the event of a lawsuit.

By contrast, if you filed bankruptcy, then you would have much broader protections under federal law. In bankruptcy, you would have an automatic exemption of $1 million, an exemption which is adjusted periodically for inflation ($1,245,475 as of 2013). This exemption would be enough for most people, and so bankruptcy would be your fallback position in the event you needed maximum protection. Also, knowing that you have this option might increase your negotiating leverage with an unpaid creditor.

Inherited IRA’s:  However, this automatic bankruptcy exemption would not apply in the event your IRA were an Inherited IRA, for example if you inherited the IRA funds from your parent by reason of your parent’s death.  The US Supreme Court ruled on this point just last month in a case called Clark vs. Remeker, finding that inherited IRAs are not “retirement accounts” as they no longer serve the purpose of funding the original owner’s retirement.  However, there still may be discretionary protection under state law based upon the “necessary for support” standard.

Rollover IRA’s: Upon retirement, many employees roll over funds from their employer-sponsored Profit-Sharing or 401(k) plan into a Rollover IRA.  If these funds came from an employer sponsored plan managed in compliance with the Employee Retirement Income Security Act (an “ERISA” Plan), then the funds in your rollover IRA would enjoy unlimited protection, providing that you could trace the source of funds back to your employer’s ERISA plan. For this reason, I advise clients who are contemplating rollovers from employer ERISA plans to roll over these funds into a separate Rollover IRA, and not to mix them with their own Traditional IRA. This strategy extends unlimited protection to the funds in the rollover IRA, no matter the amount.

Spousal Rollovers: In view of the recent US Supreme Court decision, if there were creditor concerns I would advise the surviving spouse of a deceased IRA owner to roll over the decedent’s IRA into the survivor’s own IRA, rather than to treat the decedent’s IRA as an Inherited IRA. Whether doing so  would extend protection to the rollover amount is presently uncertain, but until this matter is clarified doing so would be the wiser approach.

Special Trusts for IRA’s:  If the original IRA owner is concerned about a beneficiary’s creditor issues, the owner might consider creating a special “IRA Trust” to be the beneficiary of IRA proceeds upon the owner’s death. A properly drafted “IRA Trust” may protect inherited proceeds from a beneficiary’s creditors even in light of the Supreme Court decision.  This trust requires special planning and is not the typical “Living Trust”.

Caution:  This is a complicated area of law. Persons contemplating a bankruptcy petition, or who wish to consider a special “IRA Trust”, and who have significant funds in a retirement account, should consult with an attorney as part of their planning.