Generally, an IRA is protected from collection efforts.¹ What is less well known is that a consumer can assign his or her IRA to a financial institution as collateral for a loan and this act allows a non-custodial financial institution to collect what is due to them from the account upon delinquency because the consumer has waived their IRA protections. Normally, an IRA “to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986” is protected from a bankruptcy proceeding up to a maximum of $1,711,975.² However, when the taxpayer engages in a prohibited transaction under 26 U.S.C.A. § 4975 such as the “lending of money or other extension of credit between a plan and a disqualified person” then the plan is no longer considered a tax-exempt qualified retirement plan by the IRS and is not protected from creditors.³
Multiple Ways to Lose IRA Protections
Multiple examples exist of prohibited transactions involving a traditional IRA, such as borrowing money from it, selling property to it, using it as security for a loan, and buying property for personal use (present or future) with IRA funds, to name a few.⁴ Engaging in a prohibited transaction with your IRA account results in the account ceasing to be an IRA “as of the first day of that year.”⁵ Once an IRA ceases to be an IRS recognized retirement account, it loses the exemptions provided under 11 U.S.C. § 522 and some state laws. If through prohibited activity an IRA loses its tax exemption and creditor protection, then a non-custodial financial institution may recover from the account.
Personal Borrowing or Benefit From the IRA
One way a traditional IRA loses its tax-exempt status and creditor protection is when the holder borrows money temporarily from the IRA with the intention to repay it later with interest. An account holder borrowing money from their IRA is a prohibited transaction causing the IRS to treat the action as a full distribution of the funds, making the entire IRA’s value taxable and subjecting the account holder to additional penalties.⁶
An IRA account holder can forfeit their IRA’s tax-exempt status and protection against creditors when they sell to the IRA property they first owned as an individual. For example, an IRA, or an IRA owned entity, is not allowed to buy rental property from the account holder or the IRA will forfeit its privileges.
Another way an IRA can lose its tax-exempt status and protection from creditors is when the holder buys a commercial building with the IRA and rents out all but one office which they use for their personal business; a personal benefit of any kind is contrary to the investment for retirement purpose of the IRA and will result in the IRS disqualifying the entire account. An IRA account holder can also lose their IRA’s tax-exempt status and protection against creditors when the holder makes a direct or indirect loan from the IRA to a disqualified third party.⁷
These four ways an IRA holder might forfeit their IRA’s tax exemption and creditor protections, while perhaps the most common, are not an exclusive list. See 26 U.S.C.A. § 4975 (c)(1) for the statute that enumerates all of the prohibited transactions, including less common infractions, some of which occurred in the In Re: Barry K. case.
In the case In Re: Barry K., Kellerman self-directed his IRA to make prohibited transactions to Panther Mountain Land Development, LLC, who was a disqualified person under 26 U.S.C.A. § 4975:
. . . Panther Mountain is a disqualified person. Any direct or indirect loan from the IRA to Panther Mountain is a prohibited transaction. . . . Furthermore, even if the transaction at issue were not a loan, the IRA would still have lost its tax exempt status because the Kellermans and Panther Mountain benefitted directly from the transactions in violation of 26 U.S.C. § 4975 (c)(1)(D) and (E).⁸
This case confirms a single not-strictly retirement focused transaction can cause an IRA to lose its tax-exempt status. Certainly making a loan from IRA funds, or using the account indirectly to secure a loan, suffices to sever the collection protections an IRA holder normally enjoys. Kellerman’s IRA was a part of no less than three types of prohibited transactions (loan to a disqualified person, use for the benefit of a disqualified person, and a disqualified fiduciary engaging in serving self-interest), any one of which would have been sufficient to strip the IRA of its tax exempt status under 26 U.S.C. § 4975 (c)(1).⁹
Example From Minnesota Case Law
An IRA loses its tax-exempt status and creditor protection when the holder pledges the IRA as security for a loan since this is a type of indirect loan from the IRA. A Minnesota court decided an IRA holder had not violated his tax-exempt status and was thus safe from garnishment on the IRA account when he held up his IRA as an asset to help him get a loan, but it was made clear during the underwriting process that the financial institution involved was not free to cash out the IRA as collateral for the debt:
We conclude the letter guaranteeing that appellant would not cash the certificate before the maturity date did not give the bank any “security” as defined in the IRC. The letter did not grant the bank any rights in the IRA or in the CD but only a right to hold appellant to his agreement to delay cashing the CD until its due date. At no time did appellant or the bank state or imply that the bank would be able to use the CD to satisfy the loan if Machine Power defaulted. Thus, the only enforceable obligation appellant made was that he would not cash the 5–year certificate of deposit before five years had passed or until the loan was repaid. Perhaps this agreement was part of an enticement package necessary to obtain the loan on behalf of the company. Such a use of an IRA, however, is not prohibited. Only when the use becomes “security,” is it prohibited. This promise alone is not sufficient to constitute a “use” of the IRA as “security for a loan” as required by the IRC.¹⁰
So, the question of whether an IRA owner assigned an account as security for a loan is sometimes a nuanced determination of what degree of commitment the assets incurred. Any doubt in the matter is likely to be decided in favor of the account holder. But if an IRA owner is found to have assigned the IRA account as security for a loan, they will lose their account’s tax exemption and creditor protection.
Custodians Cannot Collect
Crucially, if the financial institution is a fiduciary or a custodian over the same IRA for which they hold an assignment, this prevents them from collecting against the account.¹¹ An IRA’s custodian is the IRS approved financial institution that holds the IRA and ensures all governmental regulations concerning account administration are followed. It has been said, “where the liability of the one claiming a set off arises from a fiduciary duty or is in the nature of a trustee, the requisite mutuality of debts does not exist, and such person may not set off a debt owing from the debtor against such liability.”¹² Because a financial institution cannot collect against an IRA they have custody over, there could be a scenario where a financial institution is assigned an IRA by the account owner as collateral for a loan, causing the IRS to automatically revoke the IRA’s exempt status, but the custodial financial institution still cannot legally receive funds from the old IRA account.¹³ This scenario should make a prudent administrator think long and carefully before accepting an IRA as collateral for a loan.
Best Practices
For financial institutions considering taking an IRA assignment as collateral, the best practice is (1) to require the borrower to clearly assign the IRA to the lending institution as security for the loan, (2) the lending institution should not be the custodian of the IRA or a fiduciary towards the account, and (3) the customer should sign (out of an abundance of caution and in keeping with ethical standards) a disclosure indicating they understand they are waiving their IRA protections (which will mean not only a creditor risk to the account assets, but also immediate taxation as ordinary income, plus stiff penalties ranging from 15% to 125% of the amount involved in the prohibited transaction).¹⁴
Furthermore, there are state-specific statutes that relate to IRA collection concerning situations beyond federal bankruptcy (lawsuits, divorce, etcetera); so knowing the applicable law in your jurisdiction is always crucial when contemplating accepting an IRA as collateral.¹⁵
Conclusion
In summary, as a matter of federal law, a financial institution can only collect on an IRA portfolio worth less than $1,711,975 in an exceptional circumstance. If the holder of an IRA has waived the account’s federal tax-exempt status by engaging in an IRS prohibited transaction, such as making an assignment of the account to a financial institution, a disqualified person under 26 U.S.C.A. § 4975, then a non-custodial financial institution may collect on the IRA. Since the best lending practices would require a clear assignment of the IRA by an informed consumer to a non-custodial financial institution, in practice this exception to the rule that financial institutions generally cannot collect against IRAs will likely rarely be used; but it may be helpful knowledge to have in some lending and bankruptcy scenarios.
1 First Nat. Bank of Blue Island v. Philp’s Est., 106 Ill. App. 3d 360, 362, 436 N.E.2d 15, 17 (1982) (the court explained that even after the death of the account holder a bank could not set off funds from the IRA balance to cover the depositor’s debts to the financial institution).
² 11 U.S.C.A. § 522 (d)(12); 11 U.S.C.A. § 522 (n)(assets in IRA accounts are protected from bankruptcy creditors up to a combined $1,711,975, adjusted every three years for inflation, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005).
³ 26 U.S.C.A. § 4975 (c)(1)(B); In Re: Barry K., 538 B.R. 776, 779 (E.D. Ark. 2015).
⁴ IRS Publication 590-B (2024).
⁵ Id; see also 26 U.S.C.A. § 408 (e)(2).
⁶ Roth IRAs are an exception to this prohibition against IRA borrowing insofar as you are allowed to remove post tax contributions to a Roth IRA, but not the growth, penalty free; these contribution withdrawals can be “borrowed” from the ROTH IRA if returned within 60 days via an IRA rollover (including back to the original account).
⁷ Peek v. Comm’r, 140 T.C. 216, 225 (2013).
⁸ In re Barry K., 538 B.R. at 779.
⁹ 26 U.S.C.A. § 4975 (e)(2)(definition of a disqualified person includes a corporation that owns 50% or more of “the total value of shares of all classes of stock of a corporation”).
10 Est. of Jones by Blume v. Kvamme, 481 N.W.2d 94, 97 (Minn. Ct. App.)(further litigation occurred here which visited the Minnesota Supreme Court twice on appeal, but it was concerning the constitutionality of certain state statutes under the Minnesota constitution and did not examine the federal law matters addressed here).
11 In re Sopkin, 57 B.R. 43, 49 (Bankr. D.S.C. 1985)(discusses how an “IRA custodian is precluded from asserting any claim to the assets in an IRA”).
12 4 Collier on Bankruptcy Sect. 553.04 at page 26.
13 IRS Code § 408(e)(2).
14 Sopkin, 57 B.R. at 49 (speaking on “penalty imposed by IRS for any such withdrawal”);
IRC § 4975(a)-(b)(discussing 15% excise tax on amount involved in prohibited transactions which increases to 115% if not corrected in tax period); 26 U.S.C.A. § 72(t)(2)(A)(i)(early withdrawal penalty is normally 10% for those under age 59.5).
15 IRA Asset and Creditor Protection by State, IRA FINANCIAL (Apr. 18, 2025), https://www.irafinancial.com/blog/ira-asset-and-creditor-protection/.
