IRA and 401k plans have been long thought to be fully protected from creditors. In recent years limitations on that protection have been put in place, usually for bankruptcy purposes. Since 401k plans are covered by a trust that contains a “Spendthrift” clause, creditors are not permitted to attach or garnish the participant’s interest. If a participant dies and her interest in the 401k plan has not been “rolled over” into an IRA, the balance in the plan, still covered by a trust, is still protected. IRAs operate differently and are covered by custodial agreements and not trusts. The protection afforded the owner of an IRA is a function of statute, either the exemption statutes for each state or the exemptions provided under the bankruptcy code.
Creditors have been working for years on ways to reduce or eliminate the exemption on either the state or federal level. In Minnesota, the exemption for an IRA or 401k (or any form of retirement plan qualified under the Internal Revenue Code) was unlimited for many years. Finally, as a result of apparent abuse, the courts stepped in to force limitations. Currently, in Minnesota, an IRA or 401k interest is exempt in the hands of the participant or her beneficiary to the extent of $69,000 plus amounts that the owner can show are necessary to support the participant and her dependents (this amount is adjusted periodically). At the federal level, an IRA is exempt to the extent of $1, 245,475 which amount may be increased “if the interests of justice so require”. If the owner of the IRA files for bankruptcy protection, they have the choice of using the state or federal exemptions, which ever provides the better protection. For those in Minnesota and throughout the Eighth Circuit, the federal exemptions will usually provide better protection for retirement plans.
However, next door in Wisconsin and throughout the Seventh Circuit, the federal court has ruled that the exemption will depend upon the status of the owner of the IRA. In the case of In re Brandon Clark, the court held that a debtor's inherited IRA may not qualify for a bankruptcy exemption under Bankruptcy Code §522(b)(3)(C). As we explain below, the Seventh Circuit decision conflicts with decisions of both the Fifth and Eighth Circuits. The Supreme Court has agreed to accept the case to resolve the conflict. (Clark, Brandon C., In re (2013, CA7), 714 F.3d 559, 2013 WL 1729600 , cert granted (2013, S.Ct.) 2013 WL 4776520 )
As a matter of background, for a retirement plan asset to qualify for a bankruptcy exemption under 11 USC 522(b)(3)(C) it must meet two requirements: (1) the amount the debtor seeks to exempt must be "retirement funds," and (2) those retirement funds must be exempt from income taxation under one of several specified Internal Revenue Code provisions, including Code Sec. 408 , which provides a tax exemption for IRAs.
Let’s take a look at the facts and the Clark decision. In August of 2000, Ruth Heffron established an individual retirement account (IRA) and named her daughter, Heidi Heffron-Clark, as the sole beneficiary. Ruth Heffron died in September of 2001, and the account passed to Heidi. In December of 2001, Heidi had the balance in her mother's IRA transferred to an inherited IRA. Heidi and her husband (the debtors) took monthly distributions from the inherited IRA. Neither Heidi nor her husband were retired at the time.
In October of 2010, Heidi and her husband filed a Chapter 7 bankruptcy petition, and claimed the inherited IRA (which contained $293,300) as exempt under Bankruptcy Code §522(b)(3)(C) and under Wisconsin law. The bankruptcy trustee and a judgment creditor objected to the exemption, and the bankruptcy court ruled in their favor, denying the exemption. The federal district court, to which the decision was appealed, reversed and held that the inherited IRA qualified for a bankruptcy exemption. That decision was appealed to the Seventh Circuit Court of Appeals, which held against the debtors, Heidi and her husband.
There are conflicting decisions in at least two other federal Circuits, the fifth circuit and the eighth circuit, which includes Minnesota. Under the leading cases of Chilton v. Moser (2012, CA5) 674 F3d 486 and Doeling v. Nessa (2010, Bktcy CA8) 426 BR 312 , the funds in a debtor's inherited IRA do not have to be the debtor's "retirement funds" (a term that the Bankruptcy Code does not define) to satisfy the bankruptcy exemption requirements under Bankruptcy Code §522(b)(3)(C) or §522(d)(12). It is enough if the funds were ever "retirement funds."
The Seventh Circuit disagreed with these decisions. Unlike the courts in Chilton and Nessa, the Seventh Circuit said that the word "retirement" in "inherited individual retirement account" designated the funds' source, not their current status (i.e., as non-retirement funds). Unlike a regular IRA, an inherited IRA is a time-limited, tax-deferral vehicle, but not for holding wealth for use after the new owner's retirement, the court said. Heidi, as owner of the inherited IRA, was required to begin taking distributions under the Code Sec. 401(a)(9) required minimum distribution rules, even though she was still working. The Seventh Circuit noted that, instead of being dedicated to Heidi's retirement years, the inherited IRA had to begin distributing assets within a year of Ruth's death, and the payout had to be completed in as little as five years. Money counts as "retirement funds" only when held for the owner's retirement. However, the bankruptcy court had concluded in the case before the court that Heidi was not preserving the IRA for her retirement. Thus, the funds in the inherited IRA did not meet this standard. The Seventh Circuit agreed, finding that the bankruptcy judge "got this right."
It should be noted that the Seventh Circuit did not mention Bankruptcy Code §522(b)(4)(C), to which the courts in Chilton and Nessa referred, as support for the bankruptcy exemption of inherited IRAs. Bankruptcy Code §522(b)(4)(C) provides that retirement funds in an account that is tax-exempt under specified Code sections, including Code Sec. 401 and Code Sec. 408, do not cease to qualify for the bankruptcy exemption because of a direct transfer of those funds. The Chilton court said that this meant that the direct transfer of "retirement funds" did not alter their status as "retirement funds."
The Seventh Circuit said that by the time Heidi and her husband filed for bankruptcy, the money in the inherited IRA did not represent anyone's retirement funds, the Seventh Circuit said. To treat this account as exempt under Bankruptcy Code §522(b)(3)(C) would be to shelter from creditors a "pot of money" that could be freely used for current consumption. Thus, the Seventh Circuit reversed the district court's decision, and thereby created a conflict among the circuits.
The Supreme Court has now agreed to resolve this conflict between these circuits.
The question then becomes, what happens if the Seventh Circuit view prevails in the Supreme Court. If that should happen it is possible that retirement funds in the hands of beneficiaries will not enjoy any protection from their creditors. Given that risk those who have IRAs or other qualified retirement plans (401k and 403b plans as well as IRAs) should explore using trust arrangements for IRA funds to achieve an appropriate level of asset protection for their beneficiaries. A properly drawn trust provides protection by virtue of its “Spendthrift” clause. For those with revocable trusts (or testamentary trusts in their will) already in place, this becomes a matter of updating the trust to be certain that language required by the Internal Revenue Code is present to assure that the plan will not be taxed immediately at your death; making certain that the you have provisions in the trust regarding the beneficiaries consistent with your intentions; and naming the trust as the beneficiary of the qualified retirement plan. For those that do not have a trust in place, this is a good time review their plan with their estate planning attorney to determine what changes should be made to their plan to provide the necessary asset protection for their retirement plans. Regardless of the Supreme Court’s decision on this issue it is still likely that, with proper planning, protection can be afforded both the plan participant and the beneficiaries of the plan.
If you have any questions about your estate plan and the asset protection afforded your retirement plan, feel free to call me for a review of your plan.