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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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