This is good news if you have clients who are facing bankruptcy and have IRAs. Hopefully this will not apply to most of your clients; if most of your clients are facing bankruptcy, then you will soon follow. But if this can help even one or two of your clients protect their retirement funds, then you can be a real hero by knowing about the new rules and helping your clients through tough times.

Congress designed the bankruptcy law to curb perceived abuses by debtors in bankruptcy (although the real abuse was in naming this law and forcing everyone to repeat it without even a catchy acronym!). The new law, however, contains a silver lining of increased protection for IRAs, Roth IRAs and most company retirement accounts. But this protection only applies to bankruptcies, and it doesn't protect IRAs from other judgments the way that federal law (specifically ERISA) now protects qualified plans.

The new law revises the exemptions under Section 522(b)(3). Retirement funds in plans that are exempt from federal income tax under Code Sections 401, 403, 408, 408A, 414, 457 and 501(a) are now exempt from the bankruptcy estate. This covers qualified retirement plans such as 401(k)s, 403(b)s, IRAs, Roth IRAs, governmental plans and tax-exempt organization plans.

WHERE CAPS APPLY

Currently there is an inflation-adjusted cap of $1 million on IRAs and Roth IRAs. This cap can be increased at the discretion of the Bankruptcy Court, and it does not apply at all to certain types of rollover contributions.

Since this cap applies only to IRA or Roth IRA contributions and earnings on those funds, the bankruptcy law protects virtually all funds in IRAs even if the total balance exceeds $1 million. That's because it's unlikely that anyone has accumulated over $1 million in an IRA from making annual IRA contributions, even if they have contributed the maximum amount for the 31 years that IRAs have been available.

For example, if you had contributed the maximum to an IRA each year from 1975 to 2005, you would still only have made $63,500 in contributions ($65,500 if you qualified for the age 50 or over catch-up contributions available beginning in 2002). And it's highly unlikely that the earnings would be able to push your IRA balance over $1 million, even if you had contributed the maximum amount each year.

Most of the funds in larger IRAs originally came from company plan rollovers, and the $1 million cap does not apply to these rollovers. Rollovers from company plans are exempt from the bankruptcy estate, and there is no limit to this particular protection.

For example, assume that a client has $6 million in an IRA (doesn't everyone?). Further assume that $5.8 million is from funds the client rolled over from a 401(k) and earnings on those funds, and the remaining $200,000 is from annual IRA contributions and earnings on those contributions.

The $5.8 million in rollover funds is protected in bankruptcy under the new law since these funds are from a company plan. They don't count toward the $1 million cap because they are exempt in unlimited amounts. At the same time, the other $200,000 is protected under the $1 million exemption, so all $6 million in IRA funds is protected under the bankruptcy law.

This is great news for your clients, of course, but it raises an important question: Exactly how will you determine how much of a client's total IRA balance is from plan rollovers?

The client will need to have kept meticulous records and some way to show how the income attributable to the rollover funds was calculated. So if a client has or expects to have an IRA of more than $1 million, you should start keeping those records now, just in case the client someday needs the new bankruptcy protection.

CONDUIT IRAS

Remember conduit IRAs? We also used to call them rollover IRAs. They were IRAs that exclusively housed money rolled to an IRA from a company plan and earnings on those funds.

But the 2001 Tax Act (Economic Growth and Tax Relief Reconciliation Act of 2001) contained provisions allowing all sorts of rollovers and plan portability so that for the most part, clients could commingle their IRA contributions and rollovers from plans in the same IRA. Beginning in 2002, therefore, conduit IRAs were no longer necessary for most people rolling over company plan funds. (The exception to this general rule was those individuals who wanted to preserve the tax break for 10-year averaging).

But the new bankruptcy law makes a distinction between IRA contributions (capped at $1 million for bankruptcy protection) and rollovers from plans (unlimited bankruptcy protection). As a result, it may be a good idea to keep plan rollovers in a separate IRA like the old conduit IRAs.

Clients who have set up a conduit IRA should take their first withdrawals from any other IRAs (the ones that contain only IRA contributions and earnings on them) that are subject to the $1 million cap. This way they can reduce the IRA amount that's subject to the cap and secure the amount in the conduit IRA that is protected in total under the bankruptcy law.

OTHER PLANS

The new bankruptcy law also affects other types of retirement plans, and there is more good news here for clients and their advisers. A quick rundown on the most relevant points follows:

SEPs and SIMPLE IRAs. These retirement plans don't count either! They are exempt just like company plan rollovers are. This makes these accounts more attractive as retirement vehicles.

In this way, the new law may unintentionally encourage more people to fund their retirement accounts. Not only are your clients saving tax-deferred funds for their retirements, but these assets can now be protected from creditors in bankruptcy. It is good to know that if your clients fall on hard times for whatever reason (for example, a small business fails and they have to declare bankruptcy), that at least their business retirement account is protected.

Solo plans for business owners. ERISA currently offers no creditor protection for Keogh or solo 401(k) plans for businesses that have no employees other than the client and his or her spouse. But the new law does protect those accounts in bankruptcy. As a result, this new unlimited bankruptcy protection could make these retirement accounts more attractive.

Rollovers in transit. IRAs and retirement accounts protected under the bankruptcy law are generally protected only as long as the funds actually stay in the retirement account. But some smart creditors might be waiting like a troll hiding under the bridge for that moment when the funds are withdrawn. Then they'll make a grab for them.

Congress already thought of that and included a provision that would protect retirement funds in transit from one plan or IRA to another. If your client withdraws any funds from an IRA and plans to roll them over to another IRA within the required 60-day period, the new law protects these funds while they are en route to the new IRA or retirement account. The troll cannot grab them as unprotected funds.

Of course, it's always best not to do a rollover by withdrawing funds from one retirement account and depositing them within 60 days to another. The preferred method is a trustee-to-trustee transfer (a direct transfer or what the IRS calls a "direct rollover"). Direct transfers are also protected by the bankruptcy law just in case a creditor can make a case that the funds were exposed for at least one second.

MORE RAMIFICATIONS

The new law appears to protect eligible rollover distributions from company plans (not IRAs) even if these funds are not rolled over. If that is the case, then your client would have to be able to show that these funds came from a company retirement account.

Of course certain distributions from plans, such as required minimum distributions, 72(t) distributions and hardship distributions are not eligible rollover distributions. Therefore, these funds would cease to be protected once they are withdrawn from the company plan or from an IRA.

Does this new law now make it safer to roll 401(k) funds over to an IRA? The answer is no. Nothing beats the rock solid protection that 401(k)s and other qualified plans have under ERISA. ERISA protection extends to judgments other than bankruptcy, and it applies regardless of state law.

What if a client were leaving funds in a 401(k) solely for creditor protection purposes, because his or her state did not protect or adequately protect IRAs from creditors? If this were a real concern, then the bankruptcy law would not offer better IRA creditor protection than the client already has with a 401(k) plan. On the other hand, the law might enhance the protection enough in bankruptcy to make the client feel a little more secure about rolling the funds over to an IRA.

IRA owners who benefit the most from the bankruptcy law are those who live in states that have poor IRA creditor protection. In those states, it could provide an increased layer of protection in bankruptcy.

For example, some states currently protect IRAs in bankruptcy for only up to $100,000. If your client lives in one of these states, the new federal bankruptcy law will increase that protection to $1 million.

Other states limit debtor protection to what's considered "reasonably necessary" to support a retired person and his or her dependents. In these states, the new law may also help protect more of your clients' assets should they be forced to file for bankruptcy.

While anyone can be sued for anything at any time, you would have to look at the trade-offs for leaving funds in a 401(k). Yes, clients might be protected from a lawsuit, but their beneficiaries might lose out on the important ability to stretch an IRA over time, which many company plans do not allow. In the end, that could cost them a fortune in lost tax-free compounding.

Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author of Parlay Your IRA Into a Family Fortune (Viking; 2005), The Retirement Savings Time Bomb...and How to Defuse It (Viking; 2003) and Ed Slott's IRA Advisor, a monthly IRA newsletter. Slott has also created The IRA Leadership Program (www.iraleadership.com) and Ed Slott's Elite IRA Advisor Group to help financial advisers, financial adviser firms and insurance companies become recognized leaders in the IRA marketplace. Visit Slott's Web site at www.irahelp.com.