By Andy Ives, CFP®, AIF®
The evil genie in the IRA lamp wants your money. He roars with laughter at the thought of you facing hard times. Given an opportunity, he will line the pockets of creditors with your IRA dollars, and he will serve your remaining non-qualified financial assets to the vultures, who will drag the accounts into the gutter and pick them clean.
The evil genie must be forced to remain inside the IRA lamp.
Fortunately, there are protections in place to keep creditors from rubbing the lamp and intentionally releasing the genie. These protections, which provide shields for bankruptcy and lawsuits, include the following:
- The Bankruptcy Code protects contributory IRAs against bankruptcy claims of up to an inflation-adjusted cap of $1,362,800. Even if you maximized your contributions since the introduction of IRAs back in the mid 1970’s, you would be hard-pressed to be above the cap with just contributed dollars, plus earnings.
- The Bankruptcy Code also fully protects (without a cap) IRA dollars that were rolled over from a company plan. This bankruptcy protection of rolled-over assets is in addition to the $1,362,800 cap referenced above.
- A third protection against unwanted people rubbing the IRA lamp and releasing the genie is provided by state law. This IRA protection is for non-bankruptcy claims (like if you get sued). But be careful! State laws vary widely. Not all states are as good at “lamp safety.”
With all these external protections, there is no way for the evil genie to escape, right? Not so fast. There is another protective step to take. While we have successfully protected the outside of the IRA lamp from claims brought against the IRA owner, the evil genie could escape with inside assistance if a claim is brought against the IRA itself.
For example, Aladdin has a self-directed IRA worth $500,000 that invests entirely in a magic carpet rental company without using an LLC (limited liability company). Aladdin has other non-qualified personal assets worth $1.5 million. A magic carpet renter falls off a flying carpet and suffers a catastrophic injury. The renter wins a $2 million judgment against the IRA. This claim is from inside the IRA lamp…and is all the evil genie needs to escape.
All of Aladdin’s IRA assets could be reached because the claim arose from activities of the IRA investment. Aladdin’s personal assets could also be at risk. However, if Aladdin’s IRA had been invested in an IRA/LLC that owned the magic carpet rental company, the LLC structure would have protected both the IRA assets and his personal assets against the $2 million judgment.
It is imperative to keep your IRA lamp protected from both the outside and the inside. Outside protection is provided for you by law. Inside protection is your responsibility. For IRA investments such as rental property, working through the steps to establish an LLC – and incurring the costs – could prove to be the most important defense against the evil bankruptcy and creditor genie.