Protect Retirement Assets

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (effective October 17, 2005) clarifies the rights of debtors and expands the protections their retirement assets have in federal bankruptcy proceedings.  But outside of federal bankruptcy things remain murky, and there still is uncertainty about whether retirement funds are subject to state attachment and garnishment proceedings.

The new law protects retirement funds by excluding them from federal bankruptcy estates.  It applies to any fund of account that is tax-exempt under IRC section 401(a), IRC section 403(b), and IRC section 457(b).

The extent of the bankruptcy exclusion for an IRC section 408 IRA varies.  IRAs created under an employer sponsored IRC section 408 SEP IRAs and SIMPLE IRAs, as well as pension, profit-sharing or 401(k) funds transferred to a rollover IRA, enjoy an unlimited exclusion from the federal bankruptcy estate.  The U.S. Bankruptcy Code now also excludes traditional IRAs and Roth IRAs.  These IRAs, which workers create and fund themselves, are subject to an aggregate $1 million exclusion limitation (adjusted for inflation and subject to increase if the bankruptcy judge determines that the interests of justice so require).

Under the new law, a rollover from a SEP or SIMPLE IRA into an IRA appears to receive only $1 million of protection.  Bankruptcy Code Section 522(n) allows a general unlimited exclusion for rolled-over qualified retirement plan wealth but does not sanction IRC section 408(d)(3) rollovers.

Case law and Department of Labor regulations have held that a qualified retirement plan that benefits only the business owner and spouse was not an ERISA plan and did not qualify for ERISA antialienation protections either inside or outside of bankruptcy.  The act now eliminates this concern for federal bankruptcy proceedings, as such plans now do qualify.

Because of the unlimited exclusion for qualified retirement plan assets transferred into a rollover IRA, you should always ensure that rolled-over retirement wealth is segregated in a rollover IRA that is distinct from other traditional or Roth IRAs that the debtor may own.

The new act does not address debtor's retirement funds that are involved in state law insolvency, attachment or garnishment proceedings.  In that case a compilation of ERISA, case law and state law comprises the relevant authority.  The major concerns are regarding owner-only plans and IRAs.  Retirement funds also can be attached through qualified domestic relations orders and federal tax liens in or outside of a bankruptcy.

Employer-sponsored SEP and SIMPLE IRAs are treated differently from individually created and funded traditional and Roth IRAs.  ERISA defines a pension plan under its jurisdiction as any plan, fund or program that is established or maintained by an employer that provides retirement income to employees.  Typically pension, profit-sharing and section 401(k) plans qualify.  The Labor Department and the Federal Court of Appeals for the Tenth Circuit held that SEP and SIMPLE IRAs also are ERISA pension plans because they are arranged by the employer, even though the contributions are immediately allocated to the employee's IRA.

Generally, ERISA pension plans receive extensive antialienation protection from creditors.  However, this protection does not extend to an IRA, including a SEP or SIMPLE IRA, even if it qualifies as an ERISA pension plan.  ERISA also contains specific preemption provisions that supersede and void state law protections specifically afforded to retirement arrangements that are ERISA pension plans (ERISA section 514(a)).

Thus, the SEP and SIMPLE IRA are at an impasse outside of bankruptcy.  They are ERISA pension plans but do not qualify for ERISA antialienation protections.  Moreover, any state law protections may be preempted, and a creditor may be able to bring a successful state action against these assets.

An individually established and funded traditional or Roth IRA is not an ERISA pension plan, so state laws can apply to protect them.  Usually the owner's state of residency determines whether the IRA is protected.  For example, Ohio law specifically exempts both traditional and Roth IRAs from execution, garnishment, attachment or sale to satisfy a judgment or order, with no cap. For a list of state laws protecting IRAs, go to www.aicpa.org/pubs/jofa/jan2006/altieri.htm.

Assets rolled over from a SEP or SIMPLE IRA into a rollover IRA should, at that point, no longer be part of an employer maintained arrangement and therefore would lose their characterization as parts of an ERISA pension plan.  The rolled over assets would not then be subject to ERISA preemption and could take advantage of state law protections for non- SEP and SIMPLE IRAs. 

As an example, Joe is a small business owner who has $750,000 invested in a SEP IRA established by his company.  Under his state's law, assets held in an IRA generally are exempted from any creditor claims.  Joe is successfully sued for $400,000 of damages in state court and is not filing for federal bankruptcy protection.

This matter is outside of federal bankruptcy law, and the new bankruptcy protections therefore do not apply.  Because Joe's money is in a SEP IRA, it constitutes an ERISA pension plan, preempting any state law directly protecting it, and it would not qualify for the antialienation protections usually afforded ERISA plans.  The judgment creditor therefore may successfully attach Joe's IRA.

If Joe transferred the money in his SEP IRA to a rollover IRA, it no longer would qualify as an ERISA pension plan.  Thus it would be protected from creditor claims up to an unlimited extent either inside a bankruptcy proceeding or outside of bankruptcy under applicable state law.

You should note the change that has occurred since the advent of the new bankruptcy law.  Wealth residing in qualified retirement plans (pension, profit-sharing and section 401(k)plans) continues to possess the most extensive debtor protections both in and outside of a bankruptcy proceeding.  A distinct IRA into which qualified retirement plan assets are rolled, an asset frequently attacked under pre-act bankruptcy law, would constitute as strong a protected reservoir of wealth under the new post-act unlimited exclusion for such IRAs in a federal bankruptcy proceeding.  Similarly, in states providing strong IRA protection the rollover IRA would enjoy unlimited protection from creditors in a non-bankruptcy proceeding. 

ERISA and the Internal Revenue Code's broad antialienation protections generally have protected a debtor's pension plan, profit-sharing or 401(k) plan benefits from creditor claims both in and outside of bankruptcy.  However, under case law and Department of Labor regulations, a plan that benefits only an owner and his or her spouse is not an ERISA plan, and so does not qualify for antialienation protections under Title 1 of ERISA.  As noted above, owner-only plans are not at risk in bankruptcy proceedings.  Outside of bankruptcy, the owner-only category does not apply if non-owner participants are added to the plan.  So the easiest way to protect funds in such plans is by adding other participants.

Qualified retirement plans and IRAs are protected under the new bankruptcy legislation.  Outside of bankruptcy, ERISA provides nearly unlimited antialienation protection to qualified retirement plans (pensions, profit-sharing and 401(k) plans).  State law generally protects traditional and Roth IRAs.  SEP and SIMPLE IRAs and owner-only plans, however, require additional planning to insulate them from creditor claims.

 

General Debtor Protections for Retirement Assets

In and Out of Federal Bankruptcy

 

	Federal Bankruptcy	State Law  Attachment/Garnishment
Qualified retirement plans   (pension,profit-sharing,    section 401(k))	Generally complete	Generally complete
Rollover IRAs	Generally complete	Generally complete
Traditional and Roth IRAs	$1 million	Generally complete
SEP and SIMPLE IRAs	Generally complete	Probably none

Note: Absolute statements of protection are problematic.  For example, qualified plan assets and IRAs are subject to attachment for qualified domestic relations orders and federal tax liens both in and out of bankruptcy.  Additionally, owner-only plans may be attachable outside of bankruptcy.  State law protections vary from state to state.