Ask an advisor: Which retirement plan is safer from lawsuits, a 401(k) or an IRA?

Ask an advisor: Which retirement plan is the safest from lawsuits?

May 17, 2023 6:33 PM

Not all retirement plans are equally protected from having their contents seized in a lawsuit.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

Lots of factors go into what kind of retirement plan a person chooses to use. One element that not everyone considers is whether the plan is safe from lawsuits.

But maybe they should. There are, in fact, different rules for what can be seized from different accounts if the owner is successfully sued. Employer-sponsored plans, such as 401(k)s and 403(b)s, are regulated under federal law — specifically, the Employee Retirement Income Security Act (ERISA) of 1974. The laws for individual retirement accounts (IRAs), however, vary from state to state.

"Every state has a different law about whether creditors can attach an IRA or not," said Fred Reish, chair of the fiduciary services ERISA team at the law firm Faegre Drinker Biddle & Reath. "For example, California says you can retain the amount reasonably needed for retirement. But if you have more than that, the creditors can get to it."

Getting sued might not be high on the list of worries for a law-abiding citizen, but some types of lawsuits are quite common in the United States. Fifteen percent of Americans have reported being sued by debt collectors, according to a study by the Consumer Financial Protection Bureau. That includes medical debt — more than two thirds of American hospitals sue patients over unpaid medical bills, according to the Kaiser Family Foundation, a health policy non-profit.

Meanwhile, hundreds of thousands of Americans get sued every year for divorce. In 2021 alone, 689,308 marriages ended in divorce or annulment, according to the Centers for Disease Control and Prevention. And experts say those are the court battles where retirement plans are most vulnerable.

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"In divorce, it's very common," Reish said. "Either the plan gets divided between the spouses, or … one spouse says I'll keep the retirement plan and the other spouse says, 'That's okay, I get the house.'"

One retirement saver in New Jersey isn't taking any chances. A lawyer by trade, she knows how litigious Americans can be, and she wonders where her savings would have the best protection. Here's what she wrote:

Dear advisors,

Which retirement plan is the safest from lawsuits? I recently heard that IRAs are not as protected as 401(k)s in the event of the owner being sued. Is that true?

I'm a 35-year-old lawyer in New Jersey, and though I don't expect to get sued for any reason, I also know it can happen at any time. I have both a 401(k) and a Roth IRA, containing $52,371.91 and $43,369.77, respectively. I don't want to lose my retirement savings over a fender bender or some other dispute that gets out of hand. Should I roll my IRA into my 401(k), or vice versa?  

Thank you for your help,

Nervous in New Jersey

And here's what financial advisors wrote back:

401(k)s put safety first

Greg Goff, a certified financial planner and the founder of

Sound Wealth Management

in Greenville, South Carolina

IRAs, including Roth IRAs, are governed by state laws, and federal ERISA laws govern 401(k) plans and other qualified plans.

ERISA plans are generally protected from seizure by creditors, so monies in your 401(k) plan would typically be more protected against lawsuits than your individually owned Roth IRA.

It's all about ERISA

Ashley Folkes, a certified financial planner and the director of wealth and business planning at

American Heritage Financial

in Birmingham, Alabama

This is an important consideration during the protection phase of the financial planning process. Not all accounts are created equal, so asset location can be as important as asset allocation. ERISA-based retirement accounts or company-sponsored ones are usually protected from creditors. In some cases that involve criminal acts, they may not be fully covered.

Non-ERISA retirement accounts, such as IRAs, are a bit grayer, and the state statute determines the protection. Most IRAs are protected but have special statutory provisions, especially IRA distributions. Roth protection varies from state to state. When planning, check with a legal professional to see how your state reads. Generally speaking, ERISA-based retirement plans are a safer bet when protection is involved.

More to think about

Jeremy Eppley, an accredited investment fiduciary and the founder of

Silverstone Financial

in Owings Mills, Maryland

When a plaintiff wins damages against you in a lawsuit, they become a general creditor. ERISA-based plans, like 401(k)s, have creditor protection, while IRAs do not. If your primary goal is to protect your retirement savings from potential lawsuits, I would recommend rolling your IRA into your 401(k), if your plan allows it.

However, there are other considerations between the two account types, such as fees and investment options, that could outweigh the creditor protection benefits of the 401(k).

Consider all your options

Matt Garasic, a certified financial planner and the founder of

Unrivaled Wealth Management

in Pittsburgh, Pennsylvania

You heard correctly, IRAs typically don't have the same lawsuit protections as employer-sponsored plans like 401(k)s, because 401(k)s are covered under ERISA. That said, each state has distinct laws regarding IRA creditor protection.

The decision to consolidate your IRA with your 401(k) is multi-layered, and there are many things to consider. First of all, you would only be able to roll your Roth IRA into your 401(k) if it's a Roth 401(k). You can access the contributions in your Roth IRA tax- and penalty-free, while 401(k) funds are more restricted. Then there's the long-term impact of fees and available investment options in each account.

You are justified in your concerns about asset protection, but there are a few other options. Consider prioritizing your 401(k) contributions up to the limit before funding your Roth IRA. Umbrella insurance policies are an inexpensive way to obtain additional liability coverage above the liability limits in your property and casualty policies. You'll find you can buy an extra million dollars of coverage fairly cheaply, and it will provide peace of mind in the event of the aforementioned fender bender.