Qualified Retirement Plan Protection from Creditors
Rev. 10/30/09; E-mail Alert 2009-17

Qualified Retirement Plan Protection from Creditors
The Employee Retirement Income Security Act (ERISA) of 1974 sets standards for employee benefit plans, including qualified retirement plans. Included in the law are provisions to ensure that plan assets are protected. For example, under ERISA Title 1, participant accounts are protected from garnishment, levy, or attachment by creditors.

Generally speaking, a retirement plan that covers a common law employee rather than just an owner-employee and his or her spouse, or just the business’s partners, has ERISA Title I protection.

Exceptions to ERISA Protection
A participant’s assets are not protected from a federal tax levy or a qualified domestic relations order (QDRO). ERISA also has a provision permitting a participant’s account to be used as collateral for a participant loan. In addition, if a participant places a qualified plan distribution into an account or investment outside the plan, creditors may seek assignment of those assets.

IRS tax levy exception. If a plan receives an IRS tax levy against the account of a plan participant, the levy must be honored. However, based on guidance from the IRS, the plan may refuse to process a distribution to satisfy the levy if the participant is not yet eligible for a distributable event. If the participant is eligible for a distribution, the IRS levy may be processed — with or without the participant’s consent — after the plan’s administrative policies for IRS levies have been followed.

Although rarely used, and only in “flagrant and aggravated” cases, IRS policy does allow the levy to be enforced before a participant is eligible for a distribution. The IRS will make it clear if the levy must be treated in this manner.

If the individual is under age 59½, the 10% premature distribution penalty no longer applies, but income tax will be due on the distribution. Note that the ERISA exception regarding federal tax levies does not apply to states; state tax levies cannot be applied against a participant’s qualified retirement plan balance.
 
QDRO exception. A QDRO is a court order issued following a divorce or legal separation (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 participant’s spouse, ex-spouse, or dependent children. To be considered “qualified,” a domestic relations order (DRO) must be written according to very specific rules. If it does not meet the qualification requirements, the DRO must be returned to the court for revision.

Once a DRO has been qualified by the plan or its legal representaive, 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. One of the things a QDRO may not do is require a payment option that is not otherwise available under the plan or require a special valuation.

No Exception for a Criminal Sentence or “Bad Boy” Clause
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 the protection ERISA provides for retirement benefits.

There is a limited exception in cases where a crime is committed against the plan. Had the employee stolen $20,000 from the 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.

Using a One-time Distribution To Pay a Creditor
If a participant wishes to do so, a distribution may be used to pay a creditor provided the participant is eligible to take a distribution (e.g., he or she has terminated employment or reached age 59½). As long as the participant requests a distribution voluntarily, and not under duress, the payment may be assigned to a creditor. Once the participant makes a specific request for a third-party distribution to be made, the plan administrator must contact the third party to obtain an acknowledgement that the payment may be made.

Paying a Creditor from Installment Distributions
A participant who is receiving installment distributions may assign an amount to be paid to a creditor from his or her installment or annuity distributions. However, under ERISA, no more than 10% of each payment may be paid to a creditor. In addition, the participant must be allowed to revoke the assignment. 

Participant’s Interest in the Plan Excluded from Bankruptcy Estate
A participant’s assets in a qualified retirement plan are protected from creditors in the event of a bankruptcy, whether or not the plan is subject to the protections of Title I of ERISA.

Bill Grossman, ERPA, QPA

Learn more about this and other topics in our Back-to-Basics eSeminar series. Click here for information and/or to register.