A 401(k) is the place where most Americans create a nest egg for their golden years. But what if a future medical emergency creates a financial hardship: will your 401(k) investments remain protected from debtor claims? We looked into this question in detail, and here’s what came out of it.
Can 401K Be Garnished for Medical Bills
Private creditors cannot seize a 401(k) against medical bills or for any other purpose. However, in certain instances, the federal government could do it.
401(k) accounts are governed by the Employee Retirement Income Security Act (ERISA).
This law does not allow most creditors to tap into these funds in order to service medical bills or other debt obligations.
However, if there are any federal tax liens against your name, the internal revenue service (IRS) can seize the account to pay for them.
Below, we explain a few more situations where retirement funds can be tapped by those to whom you owe money.
Who Can Garnish 401K?
The IRS can attach your 401(k) assets for non-payment of income taxes.
It can also garnish the accounts if the holder is guilty of a federal crime.
Again, if fraud has been committed against the retirement plan, money can be withdrawn to repay fines imposed by a civil or criminal judgment.
In certain states, creditors could also seize retirement savings if they are held in an individual retirement account (IRA).
One more possibility is ex-spouses.
They can take legal action to collect money from retirement accounts for alimony or child support obligations.
Is a 401K More Protected than an IRA?
Yes, 401(k)’s are exempt from creditor claims, whereas, in some states, individual retirement accounts (IRAs) are not (as mentioned earlier).
The reason is that while the former comes under ERISA, state laws determine asset protection for the latter.
In places like Georgia, only the undistributed balance of IRA accounts under $1,245,000 is protected.
For such states, investors should double-check the applicable rules.
It might serve them better to leave their savings under their 401(k) rather than moving them to non-ERISA retirement accounts.
What Is a Medical Hardship?
Medical hardship is a term used to describe financial problems caused due to cost of medical care.
For example, a lack of insurance or excessive healthcare expenses that remain uncovered can create hardship.
Patients may end up with huge amounts of debt and might even face bankruptcy due to these problems.
Medical hardship can cause mental stress and lower the quality of life of the concerned individual.
It can also cause a lack of access to medical care.
Some common issues that can arise are the inability to purchase medication or missing doctor’s appointments in an effort to save money.
Can You Take a Hardship Withdrawal from 401K for Unreimbursed Medical Expenses?
Yes, unreimbursed medical expenses are one of the four situations where a hardship withdrawal from a 401(k) is allowed.
The other three include college tuition for self or dependant (due within the next 12 months), down payments on a primary residence, or preventing a foreclosure from your home.
Moreover, the payments could be for you, a spouse, or even a dependant.
In fact, 28% of those who apply for withdrawals do it for this particular reason.
However, it is important to understand that there must be an immediate and pressing need for the application to be considered. You would need to prove the above in order to secure the withdrawal.
The decision to approve is taken either by a committee or a designated representative who agrees to take responsibility for doing so.
Moreover, such determinations are never as simple as just checking some documents.
They look into a lot of contexts, and the process can be very stringent.
To add to the problem, hardship withdrawals are taxable events.
A 20% deduction will be made on the amount even before it reaches your pockets.
For those below 55 years of age, an additional 10% penalty is also applicable.
Thankfully, the last clause is relaxed slightly in case the medical bills exceed 10% of your adjusted gross income.
Lastly, 401(k) withdrawals can cause a lot of damage to retirement savings, most of which could be irreversible.
Utmost thought should be put into it before making an application to do this.
How Long Do I Have to Pay a Medical Bill?
Typical repayment schedules are within 30 days of issuance of the bill.
Note that the date of receipt may be much later, so it is important to keep track of when the invoice was generated.
This 30-day rule, however, can vary.
It is best to check with your medical provider or hospital to ensure you don’t default on your financial obligations.
Doing this can lead to interest charges and late fees being applied on top of the bill.
Your provider will initially try to incentivize repayment to the best extent possible.
They may offer a grace period or even agree to reduce some of the fees.
But beyond certain limits, the obligation might be turned over to a debt collection agency.
If it happens, all further dealing will be handled with that firm.
This can end up significantly hurting your credit scores.
What Qualifies as a Financial Hardship?
Financial hardship is a position where a debtor is unable to pay back money owed because they need all their funds for their ordinary living expenses.
A hardship doesn’t exist when it is inconvenient to repay the amount – it needs to be proved that it is impossible to do so.
Some common reasons behind this include the following:
- Loss of income
- Injury or illness
- Natural disasters
- Divorce
- Military deployment
If it is established that a hardship exists, collection of debt repayments can be suspended for some time by creditors.
This is especially true if there is a reasonable expectation of changes in the financial situation of the person sometime in the future.
How Do I Protect My Retirement Assets from a Lawsuit?
There are several strategies available to individuals to protect their assets from potential claims, seizures, and lawsuits in the future.
We describe seven of the most commonly used ones below.
Retirement Plan Contributions
As mentioned earlier, a 401(k) is safe from nearly all types of creditors except for any financial obligations to the IRS.
Moreover, even a non-ERISA retirement account is protected up to a certain extent, depending on state laws.
Contributing as much as allowed to these plans can help keep your assets safe.
Purchasing Insurance
Claims against retirement assets can come from various sources. But insurance can help to keep your money protected in most cases.
You can opt for either umbrella plans or specific ones that cater to certain damaging situations.
This may include cyber liability, professional liability, malpractice, homeowner’s liability, errors, commission, and so on.
Asset Transfer
Creditors cannot seize anything that does not belong to you directly.
Hence, one way to protect assets is simply to transfer them under a different name using an unbreakable trust.
However, this can work only if there are family members or persons in who you have absolute faith.
Re-Titling
For married couples, one effective way to shield property from lenders is to hold it as “tenants by the entirety.”
This is a legal arrangement that confers equal ownership rights to both parties in a marriage.
Since neither spouse is the sole owner of the home, it cannot be garnished for individual debts.
However, it does not protect the house if the mortgage is also jointly held.
Domestic Asset Protection Trust (DAPT)
A DAPT lets the holder be a beneficiary to itself while also affording asset protection.
It is available in only a few states, but a person does not need to be a resident to make one.
These trusts provide varying degrees of safety, which varies as per the location.
For example, Nevada and South Dakota are often considered to offer the best options with regard to debt claims.
Establishing the proper structure and funding for a DAPT is very important.
This is because their enforceability on a resident of another state can easily be challenged legally.
LLC or FLP
Establishing a limited liability company or a family limited partnership is an easy option for both protecting assets and distributing wealth among family members.
Simply create either one of these entities, transfer assets to it and distribute its shares to yourself or family members.
Personal creditors will not be able to seize assets owned by the LLC or FLP.
Offshore Trusts
This is one of the more complex strategies for protecting assets.
Certain countries allow individuals to form irrevocable trusts under their jurisdiction.
They do not recognize judgments issued in American courts, and this can make it very difficult for potential creditors to seize assets.
Some also allow the trusts to be revocable after a certain period of time.
One key requirement for this strategy is to ensure proper reporting of information to the American authorities.
For example, any interactions and financial returns from offshore trusts need to be reported each year.
Failure to do this can cause substantial penalties to be levied.
Final Thoughts
If you believe that a future hardship or debt obligation might cause creditors to seize your assets, there are many ways to keep them safe.
The easiest one available to most people is putting as much money as possible into a 401(k) or other retirement accounts.
The first one offers both asset protection and the possibility to withdraw money if medical expenses create a hardship.
Only the IRS can seize funds from a 401(k) in lieu of unpaid federal income tax debts.
Other available alternatives include taking insurance, asset transfer, re-titling, and so on.
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