For U.S. persons, retirement accounts not only offer tax deferral, but protection from seizure in a lawsuit. Self-directed accounts, especially self-directed IRAs, also let you invest in assets not easily accessible through ordinary IRAs, such as offshore real estate or offshore bank accounts. However, to obtain tax deferral and creditor protection for your IRA, you must avoid “prohibited transactions.” A prohibited transaction terminates the IRA and ends all tax deferral. You must pay income tax on most tax-deferred gains at your marginal tax, rate plus a 10% early distribution penalty if you’re under 59-1/2. Ouch! (Thank Congress for this absolute disqualification rule, which applies only to IRAs. Other types of pension and retirement plans can often recover from a prohibited transaction by undoing it and paying a 15% excise tax.) Most (but not all) states protect the value of retirement plans (including IRAs) that meet the rules for tax deferral. If you live in a state with such laws in effect, a creditor generally can’t seize your retirement plan to satisfy a judgment. Most states exempt 100% of the assets from attachment. But there are important variations, including the rights of ex-spouses in community property states, and whether protection extends to Roth IRAs, to distributions from the plan, and to inherited IRAs. The federal ERISA law protects assets in an employer-sponsored retirement plan, but only in bankruptcy. Not all retirement plans are ERISA-qualified, including IRAs and simplified employee pension (SEP) plans. However, in 2005, the Supreme Court ruled these plans are protected as well. The 2005 Bankruptcy Reform Act also exempts IRAs and other non-ERISA-qualified retirement plans or similar contracts from creditor attachment. IRAs are protected up to maximum value of US$1 million. But again, no protection exists if the bankruptcy trustee discovers you’ve engaged in a disqualified transaction. In a recent case, a Florida bankruptcy court ruled that creditors could seize all funds in two of an individual’s IRAs, and $60,000 in a third. The first account became vulnerable when the IRA owner borrowed funds from his IRA and used the assets to pay off a mortgage. He then acquired the property and subsequently sold it. This was one of several prohibited transactions in the owner’s account. As a result, the IRA was terminated and lost its exempt status. The second and third IRAs were terminated because they contained funds rolled over from the first IRA. The result would have probably been the same if the IRA owner relied on state-law exemptions. The bankruptcy trustee could again have sought to terminate the IRAs due to the prohibited transactions. This would have ended all asset protection and tax deferral. The bottom line: If you have substantial assets in a retirement plan, avoid prohibited transactions. If you’re not sure what’s prohibited, start educating yourself by reviewing this advice from the IRS . Otherwise, you may not just lose the assets to creditors, but also face a hefty tax bill. Copyright © 2009 by Mark Nestmann
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"Disqualified Transactions" in Your IRA Can End Asset Protection–and Tax Deferral, too
