Bankruptcy protection qualified plan versus IRA

[ldr]

Hi to All,

A client has a profit sharing plan currently with only the owner and his wife as participants.  They want to invest the assets in a real estate program of some sort and have decided to terminate their plan and roll their funds to an IRA for each of them.  Each IRA will invest in the real estate.

The question came up as to whether it would be better to keep the money in the plan and let the plan invest in the real estate, because there would be more bankruptcy and creditor protection within the plan than outside of it.  Is that true?  Does the answer change when only a husband and wife are participants?  Does the answer change if they amend and restate the profit sharing plan as a Solo 401(k) plan?

Thanks in advance for any advice!  I did look on the internet and found one article that states there is absolutely more protection within the current plan, and yet another one that said there is some kind of exception to that protection for Solo 401(k)s.  We're confused.....

 

[ESOP Guy]

You might want to do a search on this board on the term "real estate" to find the many discussions of all the problems having real estate has in a Qualified Plan. 

I know not answering your actual question but I will let one of the topic experts tackle that one. 

[ldr]

@ESOP Guy I know, you are right about that, and the fact of the matter is that we don't really know anything about this real estate investment.  It's in some sort of trust administered by a local bank but that's all we know.  We do have a call in to the bank to try to get a better idea of what this is.  That's our next step, and if this is going to get really ugly, they can move the money to the IRAs and we will be out of the loop.

[401_noob]

When studying for my DC-1 exam there was a paragraph or two about bankruptcy protection afforded qualified Plans and the Bankruptcy Abuse Prevention and
Consumer Protection Act (BAPCPA) of 2005. The text said that BAPCPA currently protects up to $1,242,475 in an Individual Retirement Account (IRA).

The text also says that the limit on protection does not apply to funds rolled into an IRA from a qualified Plan.

Don't know if this is the bankruptcy and creditor protection you were looking for.

Hope it helps!

[Lou S.]

I'm not a lawyer and bankruptcy is not my specialty but my understanding is

Qualified Plan Assets fully protected.

Traditional IRA and ROTH assets protected up to $1M adjusted for inflation. I think it's up to around $1.25M since the passage of the law. States can grant higher limits but it varies by state.

Rollover IRA if traced back to Qualified Plan generally get the same protections as Qualified Plans.

A decent summary can be found...

https://www.investopedia.com/ask/answers/081915/my-ira-protected-bankruptcy.asp

 

 

[ldr]

Lou S., that's very helpful.  That's a big part of what we were trying to determine - whether there would be any truth in the statement that the assets would be better protected if they keep the profit sharing plan instead of rolling out to IRAs.  From what that article says, it appears that if the assets originated in a qualified plan, there is no limit on the protection extended within an IRA, so there's no particular advantage to keeping the profit sharing plan.  

That being said, if anyone knows if there is any difference between the treatment of a Solo 401(k) plan and any other qualified retirement plan, we'd like to know, since that came up along the way.

Thank you! 

@Lou S.

[Larry Starr]

Years ago, bankruptcy was an issue for assets moved into an IRA; it is no longer. Basically, the same protection is available to the assets, whether in a qualified plan or rolled over to an IRA. It is just that simple now.

[ldr]

Thanks, Larry!

[Larry Starr]

And, there is NO difference with regard to the protection because there is no such thing as a "solo 401(k) plan".  It is a marketing gimmick; I dare you to find it in the code.  It is simply a 401(k) plan that does not have (YET) any rank in file employees.  The shame of it is that those entities that market these with "bare bone documents" have no clue what happens when the employer actually does hire someone and they have to become eligible but the deficient plan document no longer works and just screws up the client.

[RatherBeGolfing]

 

53 minutes ago, ldr said:

Does the answer change when only a husband and wife are participants?  Does the answer change if they amend and restate the profit sharing plan as a Solo 401(k) plan?

Other than 401(k) contributions, is there a difference between a husband and wife profit sharing plan and a "solo 401(k)"?

*Edit: Looks like Larry beat me to it 

[ldr]

Larry and RatherBeGolfing:  Well it's comforting to know that we do that much right - we furnish the same plan document to a one man plan that we do to a corporation with hundreds of employees.  But we are a non-producing TPA, not a brokerage firm....

[Larry Starr]

THERE IS NO SUCH THING AS A SOLO 401(K) PLAN.  Now for the statement that will floor many of you: there is also NO SUCH THING AS A 401(K) PLAN.  All 401(k) plans are simply profit sharing plans (by law) that have a feature called a Cash or Deferred Option. Guess where you find the CODA in the Internal Revenue Code? Give yourself a pat on the head if you guessed IRC Section 401(k)!

The "solo 401(k)" is a marketing gimmick; usually with a disabled plan document that has the wrong provisions in it and will immediately blow up if the client actually hires someone. Of course, the client thinks that employee isn't eligible because.. .wait for it.. "IT'S A SOLO 401(K) so only I am in it!"

You don't amend a profit sharing plan into a 401(k) plan; you amend the profit sharing to ADD a 401(k) feature (a CODA).

OK; off the soapbox......

[Larry Starr]

2 minutes ago, ldr said:

Larry and RatherBeGolfing:  Well it's comforting to know that we do that much right - we furnish the same plan document to a one man plan that we do to a corporation with hundreds of employees.  But we are a non-producing TPA, not a brokerage firm....

And that's as  it should be..... EXCELLENT!

[RatherBeGolfing]

5 minutes ago, Larry Starr said:

Years ago, bankruptcy was an issue for assets moved into an IRA; it is no longer. Basically, the same protection is available to the assets, whether in a qualified plan or rolled over to an IRA. It is just that simple now.

There is an example in the EOB (CH3B - Section XI - Part B - 2.b.4)b))  where a court (Daniels v. Agin, 736 F.3d 70 (1st Cir. (Mass.)) held that a one person plan was not qualified in operation, and thereby got around bankruptcy exclusion extended to working owners in a plan that otherwise meets the definition of an employee benefit plan.  It sounds like its an outlier, but following this logic it would be worse off in a one participant plan than an IRA.  Thoughts?

[ldr]

card (thank you) :  Just when I thought I had a handle on all this, your clarification changes things:

So if the assets stay in the plan, since the plan is owner/spouse only and not covered by ERISA, there is no federal protection from creditors.  If the assets are rolled to an IRA, because the assets came out of a qualified plan, there is unlimited federal bankruptcy protection.  So in fact, the client is better off rolling the money to an IRA than he is in keeping his plan!  And we are better off because we don't really want a plan with real estate in it, in the first place.  Nothing against real estate - we just are not experts in that area and we try to avoid it.

Any thoughts to the contrary on this?

 

[card]

1 hour ago, ldr said:

The question came up as to whether it would be better to keep the money in the plan and let the plan invest in the real estate, because there would be more bankruptcy and creditor protection within the plan than outside of it.  Is that true?  Does the answer change when only a husband and wife are participants?

Assets in qualified plans covered by ERISA are generally fully protected from creditors both inside and outside bankruptcy. However, plans covering only the owner, or the owner and his/her spouse, are generally NOT covered by ERISA, so they receive no federal protection from creditors outside of bankruptcy--state law applies. They do receive full protection from creditors in bankruptcy.

Similarly, IRAs are not ERISA plans, so they also don't receive any federal protection from creditors outside bankruptcy--state law applies. And as mentioned earlier, federal law currently limits IRA protection in bankruptcy to $1,283,025 (aggregate of all traditional and Roth IRAs owned). However, that cap doesn't apply to amounts rolled over from employer qualified plans or 403(b)s. Those rollovers, and any applicable earnings, retain unlimited federal bankruptcy protection. (The cap also doesn't apply to SEP or SIMPLE IRAs.

 

[card]

2 minutes ago, ldr said:

So if the assets stay in the plan, since the plan is owner/spouse only and not covered by ERISA, there is no federal protection from creditors.  If the assets are rolled to an IRA, because the assets came out of a qualified plan, there is unlimited federal bankruptcy protection.  So in fact, the client is better off rolling the money to an IRA than he is in keeping his plan! 

Assets in the plan continue to receive unlimited protection from creditors in bankruptcy. But if it's not an ERISA plan, they receive no protection outside of bankruptcy--state law applies. So in both cases there would be unlimited bankruptcy protection. Whether the owner is "better off" rolling over to an IRA would depend on what protection the state provides outside bankruptcy to IRAs v employer plans.

*I deleted my original post and re-posted, but in the meantime LDR responded to my initial post. That's the reason for the funky sequencing...

[RatherBeGolfing]

1 minute ago, card said:

*I deleted my original post and re-posted, but in the meantime LDR responded to my initial post. That's the reason for the funky sequencing...

Hah I thought I was going crazy for a while...

8 minutes ago, card said:

However, plans covering only the owner, or the owner and his/her spouse, are generally NOT covered by ERISA, so they receive no federal protection from creditors outside of bankruptcy--state law applies. They do receive full protection from creditors in bankruptcy.

I'll admit that bankruptcy is not my specialty, but the EOB suggests that the full protection from creditors in bankruptcy is not automatic for an owner only plan.  It would require the plan to be "qualified in operation", and one case cited was held to not be qualified in operation because of prohibited transactions under §4975 (that  the IRS considered corrected!).  

 

 

[ldr]

Ok, I know when I'd better quit.  Let them merrily roll their assets to the IRA and we won't even think about trying to hang on to this plan.  Next week I am going to look into truck driving school again, if there is no upper age limit for acceptance.  However, thank you all for your answers, and have a good weekend!

[card]

1 hour ago, RatherBeGolfing said:

I'll admit that bankruptcy is not my specialty, but the EOB suggests that the full protection from creditors in bankruptcy is not automatic for an owner only plan.  It would require the plan to be "qualified in operation", and one case cited was held to not be qualified in operation because of prohibited transactions under §4975 (that  the IRS considered corrected!).  

I took a quick look at the case. It didn't turn on the plan being an owner only plan. Apparently the plan in question didn't have a favorable determination letter as of the date the owner filed for bankruptcy. So the owner didn't get the presumption that the funds were exempt from the bankruptcy estate. This allowed the court to go further into the statutory requirements and examine the plan's "substantial compliance" with the qualification rules...

Case is here

[Larry Starr]

On 5/4/2018 at 5:56 PM, RatherBeGolfing said:

Hah I thought I was going crazy for a while...

I'll admit that bankruptcy is not my specialty, but the EOB suggests that the full protection from creditors in bankruptcy is not automatic for an owner only plan.  It would require the plan to be "qualified in operation", and one case cited was held to not be qualified in operation because of prohibited transactions under §4975 (that  the IRS considered corrected!).  

 

 

The EOB reference (I didn't check it) appears to be a statement of what  is actually an obvious situation (and the court agreed)  If your plan is NOT QUALIFIED (for whatever reason), then you don't have the protection that a qualified plan would bring. Simple.  And, if you roll that money over to an IRA but the plan was not qualified, you now have an excess contribution to an IRA and also have no bankruptcy protection. All of which makes perfect sense.

[austin3515]

I didn;t read through everything here but all I wanted to say is this:  If you are not an attorney who specializes bankrutpcy, in my humble opinion you should NOT be answering questions about protection of assets in bankruptcy.  You can share what you've learned, but you should definitely couch it with the phrase "but if bankruptcy protection is a key area you are concerned with, you should consult with someone who specializes in bankruptcy."

My two cents.  Nothing to contradict all the advice provided about the question itself. 

Added via edit: I certainly would not want a bankruptcy attorney advising a business owner about how much he or she could/should contribute to the plan :)

[Linda Wilkins]

In choosing between the IRA and leaving the money in a qualified plan (or rolling to a new business' qualified plan), I think significant consideration should be given to the risk of prohibited transactions where investments are made in "alternative" (non-publicly traded) investments. A PT in an IRA is a nuclear bomb (see the Ellis decision, T.C. Memo. 2013-245 (2013)), whereas  it is a penalty tax/disgorgement issue for a qualified plan.  Qualified plans can also invest in "qualifying employer securities" with no similar exemption for IRAs.  In bankruptcy, you can be sure that creditors will be examining every IRA investment to find any PTs they can.  

[spiritrider]

I would add that since neither a one-participant 401k plan or IRAs receive ERISA creditor protection. That protection is subject to state law.

There are a handful of states that do not provide unlimited creditor protection for IRAs. There are also a few states that because of quirks in the way their statutes are worded do not provide creditor protection for one-participant 401k plans. I'm not sure, but I seem to remember that they were mostly or all different states.

So the bottom line is that nothing short of state specific legal counsel is sufficient to make a determination on which has the best creditor asset protection in a particular set of circumstances.

Personally, I think self-directed retirement plans are a disaster waiting to happen. I have known  more busted plans due to prohibited transactions with catastrophic consequences than plans with superior returns. Nobody ever expects it will happen to them, but it happens a lot more than the self-directed custodians will admit.

You would be doing your clients a favor by cautioning them to stick with marketable securities in their retirement plans and take their risks in taxable accounts. It will probably fall on deaf ears because their greed is driving them with tales of riches.