Employment Law/Bankruptcy Advisory Bulletin
New Bankruptcy Legislation Sets Forth
Uniform Rule for Treatment of IRAs in Bankruptcy
By James
F. Ambrose, Jeff
Belfiglio, C.
Keith Allred and Heather
G. Wight-Axling
[April 2005]
On April 20, 2005, President Bush signed the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,
which articulates a nationally uniform rule for the treatment of
IRAs in bankruptcy. This new legislation, when it becomes effective
Oct. 17, 2005, will modify how IRAs are treated in bankruptcy. However,
while the new law grants bankrupt parties more protection for their
IRAs than previously existed under federal law, it also renders
ineffective state laws that would have granted the bankrupt party
even more protection.
Bankruptcy Basics: Exclusions vs. Exemptions
Some background information about bankruptcy law is necessary to
understand the import of the changed law. When an individual files
bankruptcy, an “estate” is created which consists of
“all legal or equitable interests of the debtor in property.”
11 U.S.C. § 541. Creditors get paid only from the property
of the estate. Bankrupt parties can protect their assets in one
of two ways: by either excluding
the asset from the estate so that it never becomes estate
property, or by using an exemption to
remove it from the estate. Exclusions apply only to limited categories
of assets. For example, ERISA qualified retirement plans enjoy such
protections. As spendthrift trusts under ERISA, they are excluded
from the bankruptcy estate altogether under 11 U.S.C. §541(c)(2),
without any monetary limits or additional conditions. Patterson
v. Shumate, 504 U.S. 753 (1992). Thus, an ERISA qualified plan
never becomes property of the estate and is not subject to creditors’
claims.
Even if a bankrupt party is unable to exclude property from the
estate the federal bankruptcy law allows parties to keep a limited
amount of “exempt” property to enable them to obtain
a “fresh start.” For example, exempt assets may include
a bankrupt party’s interest in a vehicle or home (usually
subject to limits on value). Exempt assets are considered property
of the estate, but are exempt from use by the bankruptcy trustee
to pay creditors.
Exemptions exist under both federal and state law. However, in
any single bankruptcy case, the bankrupt party may use only one
set of exemptions. The bankruptcy statutes list the federal bankruptcy
exemptions. 11 U.S.C. § 522(d). Section 522(d)(10) addresses
exemptions for pensions, profit-sharing plans and “similar
plans.” Until now, bankrupt parties had used Section 522(d)(10)
to try to convince courts that IRAs were “similar plans”
and therefore exempt. These efforts met with mixed results. Recently,
the United States Supreme Court resolved some, but not all, of the
issues with regard to the applicability of Section 522(d)(10) to
IRAs in Rousey v. Jacoway, 125 S. Ct. 1561 (2005). While
the Rousey case got a lot of publicity at the time, it
will be practically obsolete under the new law.
State statutes also protect assets from being seized by creditors
under state law, which are sometimes referred to as the “state
exemptions” when they are used in bankruptcy cases. State
laws with respect to IRAs vary widely. For example, some states
specify that IRAs are protected without limitation. Other states
qualify the protection by requiring that the IRA be protected to
the extent“ reasonably necessary.” Other states have
no exemption for IRAs at all.
To complicate matters, federal bankruptcy law allows each state
to “opt out” of the federal exemption scheme. A majority
of states have “opted out” of the federal exemptions,
thereby requiring bankrupt parties who are residents of those states
to use the state exemptions. As a result, the bankrupt party’s
choice of exemptions depends on state law and will fit into one
of the following categories: (1) the bankrupt party lives in a state
that requires the party to use the relevant state exemption; (2)
the bankrupt party lives in a state that permits the use of state
or federal exemptions, and the party has selected the federal exemptions;
or (3) the bankrupt party lives in a state that permits the use
of state or federal exemptions, and the party has selected the state
exemptions.
New Exemptions for IRAs and Roth IRAs and Certain other Retirement
Vehicles
In an effort to establish uniform treatment of IRAs in bankruptcy
regardless of whether a state has “opted out” of the
federal exemption scheme, the new bankruptcy legislation gives exemption
protection to IRAs irrespective of whether the bankrupt party uses
federal or state exemptions. The new IRA protection is available
to any IRA that enjoys exemption from taxation under sections 408
and 408A of the Internal Revenue Code. (In addition, the exemption
is also available for other types of retirement funds that enjoy
exemption from taxation under Sections 401, 403, 414, 457 and 501(a)
of the Internal Revenue Code.) Even if an IRA goes through the process
of a direct rollover or an indirect rollover, such a transition
will not cause it to lose its exemption.
The new exemption is subject to a “cap” of one million
dollars. The cap will be adjusted periodically for inflation by
using the Consumer Price Index. In addition, the legislation gives
courts the flexibility to increase the cap “if the interests
of justice so require.” Notably, the million-dollar cap does
not apply to “amounts attributable
to rollover contributions under sections 402(c), 402(e)(6), 403(a)(4),
403(a)(5) and 403(b)(8)” of the Internal Revenue Code. These
sections cover rollovers from other types of plans to an IRA. Thus,
the unlimited protection for a qualified plan will not be lost or
limited if the plan distribution is rolled over to an IRA. It is
unclear what rules will apply when these rollover contributions
are commingled with non-rollover contributions. Therefore, bankrupt
parties would be well advised to keep rollover IRAs (also referred
to as “Conduit IRAs”) separate from conventional IRAs.
New Legislation May Remove Protections for IRAs that Presently
Exist
Significantly, the new legislation removes the absolute protections
IRAs enjoyed in many states and which were available as bankruptcy
exemptions for residents of those states (notwithstanding the foregoing,
those exemptions are still available for IRAs outside of bankruptcy
proceedings). Since IRAs in bankruptcy are now subject to federally
mandated treatment (and a million dollar cap), what was formerly
an unlimited exemption in some states is now subject to that cap.
State-specific examples demonstrate how this plays out in practice.
As indicated earlier, a majority of states have opted out of the
federal exemption scheme. For example, Alaska, California, New York
and Oregon (among others) require that bankrupt parties use state
exemptions. California state law exempts retirement funds only to
the extent reasonably necessary. California Code of Civil Procedure
703.140 and 704.115. The new law should significantly benefit bankrupt
parties with IRAs in California. On the other hand, Alaska, New
York and Oregon protect IRAs without dollar limits or “reasonably
necessary” requirements. Alaska Statutes 9.38.055 and 9.38.017;
New York Civil Practice Law & Rules 5205(c)(2); Oregon Revised
Statutes 23.170 and 18.358. Until now, states like Alaska, New York
and Oregon have been able to give more protection to their citizens
by opting out of the federal scheme. Now, by federalizing what was
formerly a state exemption, the unlimited protection formerly available
in those states (i.e., Alaska, New York and Oregon) will cease and
those IRAs will be subject to the million dollar cap.
The same is true for states that allow their citizens to elect
between the federal and state exemptions. Bankrupt parties living
in states with generous exemptions for IRAs no longer have the luxury
of using those exemptions in bankruptcy; instead, their IRA will
be subject to Section 522 of the Bankruptcy Code, and, if applicable,
the million dollar cap. For example, the Washington state exemption
for retirement funds is very broad and completely protects IRAs
without reference to dollar limits. Revised Code of Washington §
6.15.020. Before the enactment of the new legislation, a Washington
resident with a substantial IRA likely would elect the state exemptions
and forego the federal exemptions, assuming the primary goal of
the party was to protect his or her IRA. Now, even if a bankrupt
party from Washington chooses the state exemptions, the exemption
for IRAs will be subject to the million dollar cap.
In summary, the new bankruptcy legislation will significantly change
and clarify how IRAs are treated in bankruptcy by providing for
a uniform exemption subject to a million dollar cap for non-rollover
contributions. As a consequence, the unlimited exemption available
in some states will no longer provide unlimited protection.
Obviously, these issues are complicated and should be handled by
a professional. Parties working with IRAs in bankruptcy are urged
to consult with a Davis Wright Tremaine attorney or another professional
familiar with retirement and bankruptcy law and the applicable state
laws.
For more information on this Advisory Bulletin, please
contact:
Authors:
Other DWT Contacts:
James
C. Waggoner, Portland, (503) 778-5326, JimWaggoner@dwt.com
Joseph
M. VanLeuven, Portland, (503) 778-5325, JoeVanLeuven@dwt.com
Anne
L. Northrup,
Seattle, (206) 628-7735, AnneNorthrup@dwt.com
This
Advisory is a publication of the Employer Services and Credit Recovery/Bankruptcy
Departments of Davis Wright Tremaine LLP. Our purpose in publishing
this Advisory is to inform our clients and friends of recent developments
in employment and bankruptcy law. It is not intended, nor should
it be used, as a substitute for specific legal advice as legal counsel
may be given only in response to inquiries regarding particular
situations.
Copyright
© 2005, Davis Wright Tremaine LLP.
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