In 2005, Congress passed a major revision of the Bankruptcy Code, confirming the protected status of individual retirement accounts (IRAs) and defining the levels of debtor assets that may be sheltered by qualified retirement plans and IRAs.

Bankruptcy Law

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), debtors seeking bankruptcy protection whose net monthly income exceeds the median income in their state are required to repay a portion of their debt under Chapter 13. Before BAPCPA, debtors could erase their debt almost entirely under Chapter 7 of the Bankruptcy Code.

Retirement Plans Excluded From Bankruptcy Estate

Under BAPCPA, assets held in all qualified plans (such as 401(k), profit sharing, thrift, money purchase, ESOP, and defined benefit plans), 403(b) plans, and state and local government-sponsored 457 plans are expressly excluded from the bankruptcy estate. BAPCPA establishes guidelines for determining the qualified status of retirement plans for bankruptcy purposes. These include a favorable IRS determination letter.

BAPCPA settled an important and long-standing conflict between ERISA and the Bankruptcy Code. Under BAPCPA, participants with loans from a qualified plan must continue making payments. Participants had previously been allowed — and in some cases required — to suspend their plan loan payments.

Protection for IRAs

Although the Supreme Court, in Rousey v. Jacoway,* settled the issue of whether IRAs could be excluded from the bankruptcy estate, it did not address the federal bankruptcy law provision regarding the dollar amount that could be excluded. The decision left intact the rule that an IRA may be excluded only up to an amount reasonably needed for the individual and spouse to live on in retirement. BAPCPA provided a more specific answer to this question: Assets in traditional and Roth IRAs are protected up to a $1 million limit, without regard to rollover amounts.

Note: Under BAPCPA, funds that are rolled over to an IRA from one of the qualified retirement plans previously mentioned are excluded entirely from the bankruptcy estate. Because of this favored status, there may once again be good reason for participants to keep rollovers from retirement plans in separate IRAs and not commingle the funds with their personal IRAs. Considering that the maximum annual contribution amount for IRAs has been between $2,000 and the current limit of $5,500, the $1 million limit set by BAPCPA for IRA assets will likely provide sufficient protection for these personal accounts for the foreseeable future.

State Law Versus Federal Law

State insolvency laws will still play a role in bankruptcies. Most states require that debtors claim their state’s exemptions first, plus any additional exemptions provided under federal laws (such as ERISA). Some states, however, permit debtors to choose between exemptions provided under state laws and those provided under federal laws. In such instances, if state law protects IRA assets in excess of $1 million, an individual may choose to apply the state exemption provision. (This is a decision that should be made with the advice of legal counsel.)

Creditor Protection if not in Bankruptcy

The laws regarding protection from creditors when an individual has not declared bankruptcy are somewhat different. Assets in qualified plans covered by Title I of ERISA continue to be protected from creditors. In order to be protected by Title I, a plan must benefit a common-law employee. A plan benefiting only a business owner or the owner and spouse is not entitled to the protections of Title I.

One of the special benefits accorded to a qualified retirement plan, such as a 401(k) plan, is the protection from creditors and creditor assignments. Title I, Section 206(d) of ERISA protects a participant’s assets from creditors. Creditors may not garnish, levy, or attach the participant’s assets in a qualified retirement plan. As stated above, a plan that covers a common-law employee and not just an owner-employee and his or her spouse (or co-owners) is provided this ERISA “Title I protection.” Note that the common-law employee may be a child of the owner, provided he or she does not own any interest in the company directly.

If the plan covers one or more common-law employees, it must distribute Summary Plan Descriptions (SPDs) to the plan participants. Plans with an SPD requirement are covered under Title I of ERISA and have protection from creditors.

Note also that assets in IRAs and qualified plans not subject to Title I (such as sole proprietor plans without any common-law employees) may be protected according to a state’s laws.

* 544 U.S. 320 (2005)

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