Are retirement accounts protected in bankruptcy?

A recent U.S. Supreme Court case held that inherited IRAs are not "retirement funds." This means inherited IRAs will not receive protection in a Chapter 7 bankruptcy similar to that of a traditional IRA or Roth IRA.

The general answer is yes, but it must be qualified following a recent U.S. Supreme Court decision. As is often the case in the law, it comes down to the definition of "retirement funds" and it is not as black and white as you might imagine.

It is a general misconception that you lose all property in a Chapter 7 bankruptcy. Some property is exempt or protected to allow you a fresh start. This means that a bankruptcy trustee cannot liquidate these assets to pay unsecured debts, such as medical bills.

There are various types of retirement accounts. We will look at the three main types and their treatment in bankruptcy.

Employer-sponsored 401(k) plans and pension accounts

Most employers provide a retirement savings account as part of a benefits package. You may contribute pre-tax dollars and a generous employer may match a portion or dollar-for-dollar what you save in a 401(k) defined contribution plan.

Pensions are becoming rare, but once vested, they pay a defined amount each month during retirement.

Whatever you have invested in an employer-provided retirement account is exempt in bankruptcy. Take out the money and put it in a checking or savings account and you will lose the protection, however.

A traditional IRA or Roth IRA

Contributions to a traditional IRA or Roth IRA provide tax advantages. Contributions made to a traditional IRA are tax-deductible. Funding a Roth IRA with after-tax dollars allows the holder to take distributions tax-free in retirement. Both accounts have a 10 percent withdrawal penalty before age 59 1/2 with narrow exceptions.

These accounts accrue over time and have penalties for taking out money before retirement. Traditional and Roth accounts receive protection up to a cap of approximately one million dollars.

Inherited IRAs

An inherited IRA is either a traditional IRA or Roth IRA inherited after the death of the original owner. The recent Supreme Court case looked at whether these accounts were in fact "retirement funds" and found they were not. An inherited retirement account loses all protection in bankruptcy.

To support its decision the court differentiated the inherited accounts from typical retirement funds. For instance, the person who inherits the account is not able to add money. The holder can also withdraw the full balance at any time without penalty. And rules on these accounts even require withdrawing the funds within five years of the owner's death or taking minimum annual disbursements.

Some states have passed their own laws protecting inherited IRAs, but Tennessee and Georgia are not among them.

After losing a job or suffering through a long illness, the bills can easily mount beyond what you can repay. Bankruptcy provides relief, but exemptions are often complicated. An experienced bankruptcy attorney can explain whether Chapter 7 may provide a fresh start and how it will affect the assets that you would like to keep.

Keywords: Chapter 7 bankruptcy, Traditional IRA, Roth IRA, Inherited IRA