A new California law will reduce protections of tax-qualified retirement plans such as a 401(k) or profit-sharing plan, and affect California debtors to the point where they may want to consider moving to another state that fully exempts all retirement plans.
Debtors who want to stay in the Golden State may want to roll the liquid assets of affected plans to a self-directed individual retirement account, and then move those assets overseas.
California law, like the Employee Retirement Income Security Act, fully exempts the assets of a debtor in a tax-qualified retirement plan from creditor claims. The state also fully exempts from creditor claims the distributions from these plans if they’re deposited into a segregated bank account.
There is no similar exemption for distributions under federal law. Before this new state law, California debtors could take comfort knowing that the assets of their tax-qualified plans were protected under federal and California laws while in the plan, and under California law on the distribution.
The California protection doesn’t extend to individual retirement accounts (including Roth and SEP IRAs). IRAs are only partially exempt in California, which uses a means test to examine what assets the debtor has outside the retirement plan and how much time the debtor has until retirement. If the plan participant has significant assets outside the IRA, or has many years left before retirement, the IRA isn’t exempt under California law.
The new law amends California Code of Civil Procedure Section 704.115 and applies the IRA means test to tax-qualified retirement plans as of Jan. 1, 2025. This means that 401(k)s and other tax-qualified plans no longer will be exempt without limitation. Now, a judge will decide how much of the retirement plan is needed for living expenses and how much can be handed over to a creditor. This will shrink the amount of wealth that will be immune from creditor seizure.
Fortunately, federal law limits the application of the new California law. Under ERISA, money in an ERISA-qualified plan is exempt from the claims against the plan participant, without a dollar limitation and with few exceptions. Because both laws cover the same subject, federal law preempts California law, and the federal protection remains in place.
Federal law doesn’t extend to distributions made from a plan. This means that starting Jan. 1, 2025, the assets of California residents held in an ERISA-qualified retirement plan will continue to be fully exempt if they remain in the plan and will be only partially exempt on distribution. The current unlimited exemption will be no more.
This new law will disrupt the asset protection advice we offer to our clients. We used to advise our California clients to roll over their IRAs into ERISA-qualified plans. This may still be a good option for clients who aren’t taking distributions or aren’t close to 73 years old (when plan participants must start taking required minimum distributions) but won’t work for others.
Debtors or those worried about asset protection should immediately consult with a lawyer on how to best protect the distributions from ERISA-qualified plans. This is particularly important for those whose plans represent a significant portion of their wealth. California law has developed to be very creditor-friendly, and the IRA means test applied to distributions from ERISA plans likely will fail to exempt many distributions.
California debtors concerned with the shrinking protection of their retirement plans may consider two options. Some debtors may leave California for a state that will afford a full exemption to their retirement plan assets. Others may be able to roll over the liquid assets of their tax-qualified plan into a self-directed IRA.
Self-directed IRAs allow plan participants a greater amplitude of investment options, including investing the assets of the plan outside the US. A creditor may have a more difficult time collecting against assets custodied in another country.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Jacob Stein is an asset protection attorney and the global chair of the private client practice at Aliant, focusing on protecting assets from creditor claims.
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