Protection from creditors for retirement plan assets.

• Author: Naegele, Richard A.

Most readers of The Tax Adviser perform at least sporadic services for their clients in the area of qualified retirement planning. Few, however, are fully aware of the unique intersection of the tax, bankruptcy, and ER ISA (Employee Retirement Income Security Act of 1974, PL. 93-406) laws in this practice area. This article will greatly help CPAs and tax lawyers come to grips with this vexing field of overlapping and, seemingly, conflicting laws.

Assets in qualified retirement plans and individual retirement accounts (IRAs) total more than $20 trillion and represent 34% of U.S. household assets.' Clients and their advisers are rightfully concerned about insulating those assets from potential creditor claims both inside and outside a federal bankruptcy action.

The rights of debtors and creditors to retirement assets in federal bankruptcy proceedings were clarified by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8 (BAPCPA), which extended bankruptcy protection to debtors' retirement funds. However, the situation was not made any clearer for debtors subject to state attachment and garnishment proceedings outside bankruptcy.

This article reviews the applicable law and provides practice resources to assist clients in protecting qualified assets from creditor claims.

BAPCPA

Key Points for Retirement Plan Assets

BAPCPA made significant changes in bankruptcy rules and added specific protections for tax-qualified retirement plans (i.e., formal employer-sponsored plans such as Sec. 401(k), profit sharing, and pension plans) and IRAs. It is effective for bankruptcy petitions filed on or after Oct. 17, 2005.

BAPCPA exempts from a debtor's bankruptcy estate retirement plan assets held by a Sec. 401(a) tax-qualified retirement plan, a Sec. 403(b) annuity plan, a Sec. 457(b) eligible deferred compensation plan (maintained by a governmental employer), or an IRA (including traditional IRAs, Roth IRAs, simplified employee pensions (SEPs), and simple retirement accounts (SIMPLE IRAs) under Sec. 408 or 408A). (2)

The exemption for IRAs was originally limited to $1 million. (3) However, the limit does not apply to employer-sponsored IRAs under Secs. 408(k) and (p) (i.e., SEPs or SIMPLE IRAs). Additionally, rollovers into IRAs from qualified plans are not subject to the limit. It appears that a rollover from a SEP or SIMPLE IRA would receive only $1 million of protection, since a Sec. 408(d)(3) rollover is not one of the rollovers sanctioned under the bankruptcy law. (4)

To make sure that an individual receives the full $1 million exemption on owner-established traditional and Roth IRAs and the unlimited exemption on IRA rollovers from tax-qualified retirement plans, it is good practice to establish separate IRA rollover and contributory IRA accounts. This will make it easier to track the separate pools of assets.

BAPCPA exempts assets in retirement plans that satisfy the applicable requirements for general tax qualification in the Code. As elaborated below, a retirement plan is generally deemed to be qualified under BAPCPA if it has received a favorable determination letter from the IRS. BAPCPA thereby increases the importance of obtaining an individual IRS determination letter for a qualified plan.

BAPCPA also exempts payroll deductions to repay plan loans from the bankruptcy automatic stay provisions. Retirement plan loan obligations are not discharged in bankruptcy. This is good for the debtor, in that plan loans will not necessarily go into default and be included in the debtor's taxable income.

Further Analysis

Determination of the tax-qualified status of plan: For bankruptcy law purposes, a fund or account is presumed exempt from tax if it has received a favorable ruling from the IRS (e.g., an IRS favorable determination letter issued to an employer-sponsored tax-qualified retirement plan). (5) Whether, and to what extent, an IRS prototype or volume submitter letter counts as a favorable IRS ruling for bankruptcy purposes is still not clear.

If the plan has not received a favorable determination letter, the debtor must demonstrate that (1) neither the IRS nor a court has determined that the plan is riot qualified, and (2) the plan is in substantial compliance with the Code or, if not in substantial compliance, the debtor is not materially responsible for the failure.

Power of court to examine plan's qualified status: Whether a court can determine that a retirement plan's tax-qualified status should be revoked and, therefore, its bankruptcy protection, is also a concern.

Retirement plan distributions: Distributions of tax-qualified retirement plan assets to plan participants receive only limited post-bankruptcy protection under BAPCPA; however, "eligible rollover distributions" remain exempt after distribution. (6) Minimum age-required distributions and hardship distributions are not protected because they are not eligible rollover distributions.

Owner-only plans are protected in bankruptcy: Before the enactment of BAPCPA, under case law and Department of Labor regulations, a qualified retirement plan that benefited only the business owner (and/or the owner's spouse) did not qualify as an ERISA plan. Therefore the plan could not take advantage of ERISA anti-alienation protections (discussed below) in bankruptcy or outside the bankruptcy process. In federal bankruptcy proceedings, this is no longer a concern if the debtor has received a favorable IRS ruling or, as discussed above, is deemed to have a tax-exempt plan.

Exception to "anti-stacking" rule: Bankruptcy Code Section .522(b)(3)(C) provides an exception for retirement funds to the Bankruptcy Code Section 522(b)(1) "anti-stacking" provision under which a debtor is generally required to choose between federal bankruptcy and state law exemptions. However, under Section 522(b)(3)(C), even debtors who choose the state law exemptions can exempt from their bankruptcy estate any retirement assets under the BAPCPA exemptions for such assets noted earlier.

Thus, in enacting BAPCPA, Congress created a new class of exemptions for certain retirement funds regardless of whether the debtor's state of domicile has opted out of the federal scheme for other, nonretirement property. For...