In situations where collection accounts get to the point of bankruptcy, each of a debtor’s individual assets will have a unique set of rules that defines whether or not they are available to settle past debts. Whether you are on the side of the debtor or the creditor, understanding these subtle differences can give you a tremendous advantage in the time leading up to bankruptcy.
One of the most subtle differences in these situations is retirement accounts held in a 401(k) versus those held in an IRA. But before we can get into how different collection laws apply to those types of accounts, we have to circle back and make sure we understand what each account represents at its core.
The Traditional 401k Account
The 401(k) account used to be the most common form of retirement savings. This is the “retirement plan” that is offered by many corporate employers, and it often includes a bonus where the employer will match the pre-tax contributions that an employee saves up to a certain amount.
That employer matching amount is the key reason that many investors stick with their 401(k) plans. Because in terms of flexibility, they are actually rather limiting. However, a 401(k) is also fully protected against creditors in the event of a bankruptcy.
The Modern IRA Account
Since many employers have moved away from offering 401(k)-style retirement packages in recent years, we have seen a number of employees choosing to invest for themselves in the form of Individual Retirement Accounts, or IRAs.
These IRAs are not affiliated with any type of employer, but still allow employees to contribute pre-tax wages in order to defer paying taxes until they actually need the income. There are also many flexibility advantages that come with IRAs, such as the ability to trade individual stocks and explore other investments that simply aren’t offered through many traditional 401(k) plans.
The one glaring downside about investing in an IRA is that the ability for creditors to get to the money you save varies dramatically from state to state. In some states like California, creditors may be able to gain access to your IRA during bankruptcy. But in states like Texas, your IRA is completely protected just as if it was a 401(k).
Rolling Your 401(k) Into an IRA
In the event that they decide to pursue a career change or more investing options, many people make the decision to roll their 401(k) investments into an IRA. And in most situations, this is a perfectly fine decision from a financial standpoint.
However, there is always the chance that you could one day find yourself in the middle of a bankruptcy proceeding in a state where your IRA is not protected nearly as well as it would be had you left your savings in a 401(k).
If you find yourself in a position where you might be obligated to roll your 401(k) into an IRA, one way to ensure that you aren’t exposing yourself more than necessary is to keep that 401(k) money in a completely separate IRA. By keeping the money completely separate, you increase the chances that it will still be protected in limited-protection states.
In many cases, meeting with financial experts to discuss the intricacies of 401(k)s and IRAs can be about as enjoyable as having your toenails removed with a sledgehammer. But if you are able to focus on protecting your assets and ask the right questions, there is a good chance that a little time investment could pay off in a big way one day down the road.