401K vs. IRA which is more protected?

One of the most common questions we answer is related to the protections around a 401K vs. the protections around an IRA.  This comes up often when a 401K is rolled over into an IRA. To understand the differences in protection we need to first look at ERISA.

Employee Retirement Income Security Act of 1974 (ERISA)

ERISA is a Federal Act which was designed to protect retirement savings from both mismanagement and abuse, as well as from loss, such as a creditor. ERISA authorized two versions of retirement savings plans:

1. Employer-sponsored plans
2. Individual non-employer sponsored plans

Employer-sponsored retirements plans under ERISA include:

• 401K
• 402(b) Plans
• Pension Plans
• SEPS
• ESOPS
• Cash Balance Plans
• Deferred Compensation Plans
• Profit Sharing Plans
• Defined Benefit Plans
• Defined Contribution Plans
• Etc.

Non-employer sponsored are considered Individual Retirement Plans (IRAs) and include:

• Traditional IRA
• Roth IRA
• SEP IRA
• Rollover IRA

While technically both types of plans were created under ERISA, the do differ substantially in several tax and non-tax ways; however, for the purpose of this article we will focus on the Asset Protection differences. 

Basically if it is an employer-sponsored plan, then it is fully asset protected from creditors, and the asset protection is very strong! The reason for this is that technically, the plan assets are not owned by the individual, but rather by the employer. 

Individual Retirement Account (IRA) differ in that there is no employer sponsor, so the plans are owned by the individual. As such, the protection for IRAs gets redirected to the State in which the individual lives.  Some states have normalized the protection and protect IRAs the same as the employer sponsored plans.  In other words, they are fully protected.  

In other states, notably California, there is a presumption of protection; however, they leave some wiggle room for a judge to use their discretion to determine if the IRA assets should be fully protected. Often this is based on considering all of the assets of the debtor. In some cases, if its a roll-over IRA then it gets the employer sponsored protection, but if it's not then it defaults to an alternative standard.

The Challenge

The challenge is that if you do have an IRA, and you are in a state that doesn't provide full protection, or at least is not clear on it, then what do you do?  Taking a distribution from the IRA is most likely not advisable as that would create a taxable situation, and in most states, even California, there is a presumption of protection. 

If you do have an excessive amount of assets in an IRA and you need more protection than your state provides, then it is possible to invest IRA funds into an asset which is difficult to liquidate or reach.  There is no one answer for these situations, so if this fits your profile, then we would recommend you reach out to us to discuss.