Bankruptcy and Retirement Plans
Rev. 07/23/10; E-mail Alert 2010-11

In Patterson v. Shumate, [112 S.Ct. 2242 1992], the Supreme Court held that the anti-assignment provision of ERISA section 206(d) is an enforceable nonbankruptcy law which results in the plan benefit being excluded from the bankruptcy estate of the plan participant. This landmark case ended the inconsistent application of the bankruptcy law to ERISA plans.

In 2005, the US Supreme Court, in Rousey v. Jacoway [544 U.S. 320 (2005)], ruled that Federal bankruptcy law may protect assets held in IRAs from attachment by creditors. However, shortly thereafter, the 2005 bankruptcy law made a major revision to the bankruptcy code sheltering IRAs up to $1 million dollars, excluding rollovers (discussed below).

2005 Bankruptcy Law
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) became effective on October 17, 2005. It requires debtors who seek protection in bankruptcy and whose net current monthly income is in excess of their home state’s median income to repay a portion of their debt under Chapter 13 rather than allowing them to erase their debt almost entirely under Chapter 7 of the bankruptcy code.

Retirement Plans Excluded from Bankruptcy Estate
Under BAPCPA, assets held in qualified retirement plans (such as 401(k), profit sharing, thrift, money purchase, ESOPs, and defined benefit plans), 403(b) plans, and 457(b) plans of state and local governments are entirely protected because they are expressly excluded from the bankruptcy estate. The law also requires that plan participants must continue making payments on their qualified plan loans rather than suspending them.  BAPCPA established guidelines for determining the qualified status of a retirement plan for bankruptcy purposes. A qualified plan with its own IRS determination letter, such as an individually designed plan or a prototype plan or other pre-approved plan that was submitted for its own determination letter, will enjoy bankruptcy exclusion automatically. If a pre-approved plan only has an opinion letter or an advisory letter or there is no determination letter, the law provides standards to prove qualified status.

IRA Bankruptcy Rules
BAPCAP excludes traditional IRAs and Roth IRAs from the bankruptcy estate, but only up to a $1 million limit, without regard to rollover amounts. Although Rousey v. Jacoway had settled the issue whether IRAs could be excluded from the bankruptcy estate on the same basis as qualified plans, it did not address the federal bankruptcy law provision regarding the dollar amount that could be excluded. Thus, Rousey left intact the rule that an IRA may be excluded from the bankruptcy estate only up to an amount that was reasonably needed for the individual and spouse to live on in retirement. BAPCPA now provides the answer to this remaining question.

NOTE: Under BAPCPA funds that are rolled over to an IRA from one of the above “qualified” retirement plans are excluded from the bankruptcy estate entirely. Because of this favored status, there may once again be good reasons for a participant to keep rollovers from retirement plans separate from their traditional IRAs and Roth IRAs and to not commingle such assets. Considering the maximum contribution amount for IRA’s has always been between $1,500 and the $4,000 current limit, the $1,000,000 limit set by BAPCPA for IRA assets will provide sufficient protection for these accounts for the foreseeable future.

State Law Versus Federal Law
State insolvency laws still have a role to play in bankruptcy. Most state laws only permit debtors to claim the state’s exemptions plus those provided under other Federal laws, such as ERISA. Some states permit debtors to choose between exemptions provided under their laws and the Federal law. Therefore, in a situation where state law provides full or greater protection in excess of $1 million for a traditional IRA, the individual may still choose to apply the state bankruptcy provision. Obviously, this is a decision that should only be made with the advice of legal counsel.

Retirement Plan Bankruptcy Protection Rules Have Changed, But the Rules in
Non-Bankruptcy Situations Have Not Changed for Sole Proprietor Plans and IRAs
The bankruptcy law provides clearly defined (and often enhanced) protection against creditors for retirement plan participants; even for participants in sole proprietor and partnership plans that cover no employees other than the business owner and his or her spouse and IRA owners who have filed for bankruptcy.

The current laws, however, concerning protection from creditors when the individual has not declared bankruptcy remain unchanged. For our article on protection of retirement assets from creditors, click here. Assets in qualified plans covered by Title 1 continue to be protected from creditors, under the provisions of Internal Revenue Code Section 401(a)(13). Assets in IRAs and qualified plans not subject to Title 1 of ERISA (such as sole proprietor plans that cover no “common-law-employees”) are only protected to the extent provided by the applicable state law (click here for our article.). So if the state law permits attachment of assets held by a sole proprietor plan with no common-law-employees that continues to be the case.

Rollover IRA Advantage – Probably not for some
An individual with a large balance in a qualified plan, for example, a physician who is concerned about potential lack of bankruptcy protection provided by an IRA, may feel more comfortable rolling over the funds from their qualified plan into an IRA. However, while a rollover IRA is exempt from the bankruptcy estate, state law continues to define the amount of protection if the IRA owner is not in bankruptcy. This could be very critical since some state laws do not protect IRA assets from creditors, such as a plaintiff who has obtained a malpractice judgment. Thus, a qualified plan may continue to provide a much greater level of security especially for professionals.

eSeminar on "What a 401(k) Administrator Needs to Know About IRAs"
Bill Grossman has created a very thorough review of the issues and ramifications of the differences between qualified plans and IRAs that a 401(k) administratior needs to know.
For more details or to register for this class, click here.