Can A Lawyer Take My IRA In A Lawsuit?
You have been served! A process server showed up at your front door and handed you lawsuit papers and now you have to show up to court. Is it possible that they can take your retirement accounts? All of that hard-earned money that you have spent time working for an employer on at your W-2 job. Can they take that away from you or maybe you have an IRA or a 401k? Are there any such thing as exempt assets in a lawsuit or bankruptcy? In short, yes there are, and we are going to cover those exactly today as the subject of this YouTube video.
By the way, if you wait around until the end of this video, I will also give you a free eBook: Five strategies to protect your short-term rentals and give you peace of mind.
Let us jump into this. Number one, we are going to take a look at the differences between a 401k protection and an IRAs protection under both federal and state law. Let us say you have a 401k. Most 401K plans in the United States are protected under the Employee Retirement Income Securities Act (ERISA). Essentially, this federal law states that it provides substantial protection for all 401K assets in the event that a creditor comes after you or even if you have to file for bankruptcy. So, ERISA generally shields all 401K assets regardless of their value so you have unlimited protection with no cap on the amount of money that you can shield from a lawsuit or from a creditor. I am going to give you an example of that here in just a minute. So complete and total protection under a 401k. Let us talk about IRAs for a minute.
IRA Protections Under Federal And State Laws
We are going to talk and break it down into two parts: you can talk about the federal side of this for protection and then we are going to talk for a few moments as it relates to state level protection. So, what about IRAs? IRAs are protected under federal bankruptcy laws for the most part. Essentially, the Federal Protection for IRAs and bankruptcy is adjusted every year. It is usually increased for inflation. Right now, we are close to around the 1.4 million mark for IRA accounts. That means you are shielded by the federal government in the event of bankruptcy of about 1.4 million dollars in an IRA account.
What about state level variations? The level of protection for an IRA in each state can vary dramatically. Let me go over a few of the differences. In some states where you receive the highest protection you can have a fully exempt IRA from bankruptcy proceedings. For instance, states like Texas, Florida and Nevada provide you complete and total protection in those States and so you know that even if you have an IRA, maybe you have a SEP IRA account or maybe you have a Roth IRA, those are going to be exempt from collection from a creditor or in a lawsuit. If you have an IRA and you have those state level protections on the other hand you have to be very careful.
You have some states that have no specific provisions for IRAs, and, in fact, you can end up being somewhat vulnerable. States like California, New York and Georgia have less protection for you to know that in the event something happens that you are not going to have to worry about that for your IRA. Now we know the protection from a lawsuit for retirement accounts generally we have covered that now for a 401k and an IRA.
Self-Directed IRA’s For Real Estate Investments?
But what if you decide to open up a self-directed IRA and now you want to dip that money into a real estate investment? Does IRA money become vulnerable the moment that you choose to invest in real estate? Well, let me just tell you right now, the simple answer to that is yes, it does. It becomes extremely vulnerable, and I want to dip back down to where we were moments ago. Anytime you start talking about possible asset protection threats to an IRA, we have to look at it from two perspectives.
Number one, first, how can a creditor collect against an IRA when they have a judgment or a claim against the IRA owner personally? So, let us say that you are the IRA owner, and someone has a judgment against you. Can they go after that IRA to exercise that judgment? And then number two, we need to talk about how a creditor can collect against an IRA or its owner when the IRA’s investments incur a claim or judgment. Two very different things, and we’re going to examine that here in just a minute.
Number one, we are going to talk about preventing creditors of the IRA owner from collecting against the IRA to satisfy the judgment. Let us talk about this for a second. Here is where an IRA provides an enormous amount of protection. We covered this a little bit already, but I want to go back to this for a minute. Let us say an individual defaults on a personal loan and gets a judgment against them. Something comes up, you just cannot pay it, you default on the loan completely. The creditor may collect from all over the place, from your personal bank accounts, from your brokerage accounts, from literally wages and all other non-exempt assets, but they cannot collect from the individual’s IRA accounts or their 401K accounts or retirement plans even in the case of a bankruptcy.
This is really important, even in the case of a bankruptcy, a retirement plan is still considered an exempt asset. What I mean by that is that this makes retirement accounts an extremely valuable vehicle to protect your assets. However, understand that is if a judgment is brought against you personally.
But now let us cover the second issue. What if you have a situation where an IRA can also be protected from claims arising out of investments and activities within the IRA? The most common example of this is when someone chooses to open a self-directed IRA to invest in a short-term rental or invest in a long-term rental or multi-family, some type of real estate investment. Here is the problem, self-directed IRA accounts can create liabilities for the IRA and maybe liabilities for the IRA owner as well.
One example: let us say you have a self-directed IRA, and you own a rental property, and the tenant slips and falls or there is some type of swimming pool accident or something serious happens there. The tenant can then sue the self-directed IRA, consequently those IRA assets, including the property and other assets within that IRA account, can be collected potentially by the creditor. Now, what about the IRA owner’s personal assets, though? Can they collect those? Here is where you have to really be aware of this. So, we know here’s the general rule, if you take an IRA and you begin to invest in short-term rentals, if you don’t have asset protection, not only can they get access to the actual property and any of the value there, but they can actually get into the IRA itself in order to exercise and satisfy that judgment.
Now, the question though is, can they also get to your personal assets outside of the IRA because you are the one who put the IRA together? That is one of the questions that comes up here. Let us say the plaintiff against the IRA decides they are going to sue the IRA, but also going to also sue the actual individual that set up the IRA personally because there is more damages here than they have in their retirement account to satisfy that judgment.
Let me give you some insight here. Under Internal Revenue Code section 408, the Internal Revenue Service basically and the government code essentially says that an IRA is merely a trust that is created when an individual establishes an IRA by signing IRS Form 5305 with a bank or a qualified custodian. Now, courts have analyzed IRAs as trusts or special deposits held by individuals for their benefit. In other words, listen, the IRA is very much treated similarly to a revocable living trust. Why does that matter? Well, because as we have talked about before on other videos, a revocable living trust by itself provides no asset protection.
If you set up an IRA account, you dip it down into investing in short-term rentals or other types of rental real estate, and then you get sued, not only can they sue into the IRA, but if there’s more damages than what your retirement account has, they can actually now sue into your individual assets and your bank accounts and anything else that you own in order to satisfy that judgment. Extremely important to understand that. So, you can face similar risks in the event of a lawsuit because now you have taken an exempt asset, which normally an IRA account would be an exempt asset, you have moved it into a high-risk asset for which you can be personally liable.
What we recommend at STR Law Guys is that anytime you are going to open up a self-directed IRA, it is really important to explore the option of taking that IRA and encapsulating it in the ownership of an LLC. Now, what happens is you are taking it out of your personal name, you are separating your possible obligation of them being able to sue through the IRA and into your assets, and you are now putting it into an LLC where you separate your ownership from the control of that asset. Very important.
An LLC prevents creditors of that LLC from pursuing the LLC owner, which would be the IRA itself, which would then also mean it would help prevent them from pursuing you individually. What do we look at here? Instead of the IRA directly owning a rental property – because this is how most people set it up – they will just take a self-directed IRA, and the IRA owns the rental property. We do not want to do that.
Now, what we would rather do is we have it owned by the LLC. The IRA purchases it, but that IRA is actually held within that LLC, and now the LLC is the one that does all the leasing out to the tenant, whether it’s the short-term rental lease, whether it’s a long-term rental, you name it, whatever it is, whatever high-risk rental activity that’s going on, it’s all going to be done now through the name of the LLC that now provides you individual protection and it also protects your IRA from a potential lawsuit. Really important that you do this so that you protect your retirement accounts when you choose to put them in real estate.
What if you are investing in something other than real estate in your self-directed IRA? Not everybody uses their retirement accounts for real estate, maybe you decided to use it for other alternative investments like a promissory note loan, precious metals, maybe land investments.
Those are not labeled as high-risk assets like you would think of as a short-term or long-term rental or even some other type of rental investment. It is really important to understand in that situation that might not be the best use of putting those assets into an LLC. We are really only talking about high-risk assets like short-term and long-term rentals here.
To take it further, one of the things that we would recommend at STR Law Guys is to also consider taking that self-directed IRA, and yes, you want it to be owned in an LLC, you place that within an LLC, but now you can actually have that LLC as a single-member owned by a holding company, whether it’s a Wyoming LLC or an Arizona Limited Partnership holding company.
By using a holding company strategy, you gain two more benefits. Number one, you establish privacy. It is going to be difficult for any potential creditor or plaintiff to be able to see who actually owns that retirement account because now you are private based upon the privacy laws that exist in Wyoming and Arizona. But secondly, you get something even more important, which is known as charging order protection. Charging order protection essentially allows you that even if you get sued and you lose the lawsuit, that creditor or plaintiff cannot make you sell that property in order to pay and satisfy that judgment. In other words, you can keep renting out the property, you can keep paying your mortgage, you can even potentially pay yourself a management fee for what you do on it cannot take a distribution, but there is so much flexibility that you have.
Why does this matter? Look, having been a previous plaintiff’s attorney who is brought these types of lawsuits, it is important to understand how this works. Essentially, you are disincentivizing that attorney from wanting to sue through to the LLC. You are creating an incentive now for them to go down to that insurance to seek an insurance settlement because they know even if they win, they kind of sort of lose. They cannot make you sell the property in order to satisfy that judgment. So, these are just a few of the examples here, and my point is to learn more about this strategy, check out this video where I discuss how to persuade a lawyer not to sue your rental property.
