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General Rule
One of the special benefits accorded to a
qualified retirement plan, such as a 401(k) plan, is the protection from
creditors and from court assignments. The Employee Retirement Income
Security Act (ERISA) Title I, Section 206(d) protects a participant’s
assets from creditors. Creditors may not garnish, levy or attach the
participant’s assets in a qualified retirement plan. A plan that covers
more than just an owner-employee and his or her spouse or just partners is
provided this ERISA “Title I protection.”
If the plan covers one or more
“common-law-employees,” it has a requirement to distribute Summary Plan
Descriptions (SPDs) to the plan participants. Plans with such an SPD
requirement are covered under Title I of ERISA and have protection from
creditors. This protection also applies to a plan that at any time in the
past was subject to the SPD requirement. If the plan no longer has
“common-law-employees,” the protection remains because it once had
“common-law-employees” and was subject to the SPD requirements.
Participant’s Interest in the Plan
Excluded from Bankruptcy Estate
The participant’s assets in a qualified
retirement plan are protected from creditors even in the event of a
bankruptcy. If the plan is covered by Title I of ERISA and the plan
includes a nonalienation provision that is enforceable under ERISA, the
plan is excludable from a bankruptcy estate.
Exceptions to the ERISA Protection
Of course, there are always exceptions to
the rule. A participant’s assets are not protected from a federal tax levy
or from a Qualified Domestic Relations Order (QDRO). Another exception is
the provision to allow the participant’s account to be used as collateral
for a participant loan from the plan. In addition, once a participant
receives a distribution of his or her assets from a qualified plan and
places them in another account or investment, creditors may then seek
assignment of those assets.
IRS Tax Levy Exception
If an IRS tax levy is received on a
participant of the plan, the plan must honor the IRS tax levy. However,
based on guidance from the IRS, the plan may refuse to honor the
processing of a distribution to satisfy the levy if the participant is not
yet eligible to receive distributions from the plan. If the participant is
eligible to make a distribution, the IRS levy may be processed either with
or without the participant’s consent after the plan’s administrative
policies for IRS levies have been completed. Rarely, in “flagrant and
aggravated” cases, IRS policy does provide for enforcement of the levy
before the participant is eligible for distribution. The IRS will make it
clear if they intend to treat the levy in this manner.
As to taxation of a distribution paid to the
IRS via tax levy, the individual will owe income tax on the taxable
portion of the distribution. If the individual is under age 59 ½, the 10%
premature distribution does not apply. When it comes to state tax levies,
the states do not have the same ERISA exception as the federal government,
thus, state tax levies can not be applied against a participant’s
qualified retirement plan balance.
QDRO
Exception
As noted above, the Qualified Domestic
Relations Order (QDRO) is also an exception. A QDRO is a court order
issued subsequent to a divorce or separate maintenance agreement that
directs a portion of a participant’s plan assets to be paid to an
“alternate payee.” The alternate payee may be the spouse, ex-spouse or
dependent children of the participant. A Domestic Relations Order (DRO)
must be written according to very specific rules to be considered
“qualified.” If it does not meet the qualification requirements, it will
have to be returned to the court for revision. Once a DRO has been
qualified, the plan administrator must follow its instructions and
segregate the affected plan assets or pay the designated sum to the
alternate payee(s), as identified in the QDRO. The QDRO rules are quite
extensive and a DRO usually requires review by an attorney to ascertain
that it meets the requirements to be a QDRO. One of the things a QDRO may
not do is require a payment option that is not otherwise available under
the plan.
Criminal Sentence or “Bad Boy” Clauses
Not Permitted
Generally, the terms of a criminal sentence
may not order the plan to pay out a participant’s benefits to a third
party as restitution, even for a crime committed against the employer. For
example, suppose an employee embezzled $20,000 from the employer. The
employer is not permitted to recover the $20,000 by taking the
participant’s 401(k) plan assets because of ERISA protection of retirement
benefits. There is a limited exception in cases where the crime was
committed against the plan. Had the employee stolen $20,000 from plan’s
assets instead of from the employer, then a Federal court or the U. S.
Department of Labor could order the plan administrator to offset the
plan’s loss against the participant’s account. In this case, the
participant is presumed to have already received a distribution from the
plan for the amount embezzled from the plan.
Using A One Time Distribution To Pay A
Creditor
If the participant desires, a distribution
may be used to pay a creditor provided the participant is eligible to take
a distribution, for example, due to termination of employment or the
attainment of age 59 ½. If the participant requests this voluntarily and
not under duress, the payment may be assigned to a creditor. Once the
participant makes the specific request for this distribution to the third
party, the plan administrator will obtain from the third party an
acknowledgement that the payment may be made to them.
Paying a Creditor From Installment
Distributions
A participant who is in installment payout
status may assign an amount from the series of installment or annuity
distributions. However, ERISA permits no more than 10% of each payment to
be paid to a creditor. The assignment must be able to be revoked by the
participant. |
