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If you're being sued by unpaid creditors, a car accident victim, the IRS or a co-parent to whom you owe support, the effects on your finances can be far-reaching. Certain assets, such as rental properties or vehicles, may be liquidated to pay damages if your cash assets or insurance aren't enough.
However, certain retirement accounts may be protected in a lawsuit. Learning how federal and state regulations apply to your 401(k) and IRA accounts is a good place to start if you're concerned about their safety in a lawsuit. Here are the basics.
What Happens to Retirement Accounts if You're Sued?
Some retirement accounts are protected in lawsuits, but the rules vary depending on the type of retirement account, the type of lawsuit and laws in your state. If you're being sued for any reason, consult with your attorney to find out how a judgment against you may affect your assets, including retirement funds.
Employer-Based Retirement Plans
Employer-based retirement plans that are covered under the Employee Retirement Income Security Act (ERISA)—including most 401(k), 403(b) and profit-sharing plans—are protected from seizure by federal law.
If you are sued for defaulting on credit card bills, for example, your creditors may not go after your retirement funds regardless of which state you live in. However, ERISA-qualified retirement funds may be tapped if you owe money to the IRS or if you're engaged in a dispute involving child support, alimony or dividing assets in a divorce.
Unlike employer-based retirement plans, individual retirement accounts (IRAs) are not federally exempt in a lawsuit. This is because ERISA-qualified retirement accounts are technically owned by your plan administrator, not you. You don't own the funds until they're withdrawn from your account. An IRA, on the other hand, is funded directly by you, and you retain ownership of the money in your IRA at all times.
And while the laws in many states protect IRA funds, specifics can vary widely from state to state. In California, for example, protection only extends to the amount necessary to reasonably support you, your spouse and family at the time you retire, taking all your assets into account. In Hawaii, the exemption doesn't apply to funds you've deposited within the past three years.
If you're being sued, ask your attorney how your retirement funds may be affected and whether there are steps you can take (or avoid) to protect your money. Depending on the laws in your state, it may or may not be advantageous to put funds into a retirement account pre-emptively.
Also, your retirement funds are generally not protected once you withdraw money from your account. Before taking any action related to your retirement funds, talk it over with your attorney.
Can Creditors Go After Your Retirement Accounts?
While commercial creditors typically can't touch your 401(k), they may be able to garnish an IRA. Retirement account protections against creditors are similar to those described above: ERISA-qualified retirement plans are usually fully protected, while IRA protections vary by state.
If you have an independent 401(k) due to self-employment, your retirement account can be seized in a civil lawsuit in some states. It's advisable to check with an attorney if you have an account that isn't fully protected from creditors and you're facing a lawsuit.
How to Protect Your Assets From a Lawsuit
What about assets that aren't held in retirement accounts? You may be able to reduce the risk to your personal assets in a lawsuit if you increase your insurance coverage, structure and insure your business as a separate entity, and consider using an irrevocable trust to hold your assets. Here's how these work.
- Umbrella insurance: An umbrella insurance policy provides additional liability coverage that goes above and beyond the limits on your personal auto and home policies. The added coverage makes it less likely a lawsuit covered under your home or auto policy will dip into your retirement funds or affect your other assets. However, umbrella policies typically don't cover business activities, intentional or criminal acts or injuries you sustain yourself. To protect business activities, you'd need a commercial umbrella policy.
- LLC or S corporation: If you're self-employed, you may want to register your business as a limited liability company (LLC) or an S corporation to help protect personal assets in the event your business is sued.
- Malpractice insurance: Similarly, doctors, lawyers and other professionals may want to carry separate malpractice insurance, to protect personal assets from malpractice suits. In some professions and states, you may be required to have malpractice insurance in order to maintain your license.
- Asset protection trust: Setting up and funding an irrevocable trust may protect your assets from creditors and lawsuits. When you move your assets—such as stocks and bonds, real estate and artwork—to an irrevocable trust, you transfer ownership to the trust. Since you no longer own the assets, they can't be considered in a lawsuit against you. You'll face legal repercussions, however, if you sign an irrevocable trust with the intention of defrauding creditors.
The Bottom Line
Whether you're planning to retire in the future or living off retirement savings now, it's worth taking the time to understand how you can protect your retirement accounts in a lawsuit. Discuss your options with an attorney who can give you the details on federal and state laws that apply in your case.
If you're concerned about the possibility of creditors taking you to court, you may also want to learn more about negotiating with debt collectors when you're having trouble paying your bills, going through credit counseling or considering bankruptcy. For an overview of the status of your credit accounts, download a free copy of your credit report. Wherever it's possible, avoiding a lawsuit may be the best option of all.