Hans Kasper, MS-CPA, PS

IRAs and Bankruptcy
 

Supreme Court Tells Creditors: “Hands Off” IRAs

Rousey v.  Jacoway, U.S.  (2005)

Individual retirement accounts (IRAs) are beyond the reach of creditors, the Supreme Court has held.  The unanimous decision preserves IRA assets for taxpayers who have filed for bankruptcy.  Their retirement savings are protected.  The decision could also spark a big movement away from 401(k)s and other plans and into IRAs.

Comment: Many people, especially individuals with high incomes, have been very cautious about moving 401(k) savings into IRAs when they changed jobs because they weren't 100 percent certain that their money would be protected from creditors.  The High Court's decision is likely to encourage people to take a much closer look at IRAs.

Comment: The High Court made no mention of the bankruptcy reform bill currently pending in Congress.  The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Sen 256), which has already passed in the Senate, would shield IRAs from creditors.  However, IRA assets above $1 million (exclusive of rollovers) would not be protected except “if the interests of justice so require.” The House is expected to take up the bill soon.  The White House has indicated its support.

The following link is a great review of this court case that specifically details why you should and how to create IRA rollover accounts for your profit sharing, 401k, SEP IRA, and simple IRA funds to make them 100% exempt from bankruptcy.

http://www.buchananingersoll.com/news.php?NewsID=1691

Background

The taxpayers, a married couple, both worked for the same company.  When they left, their employer required them to take lump-sum distributions from their pension plans.  They took their savings and opened two IRAs, one in each of their names.

The couple eventually filed for Chapter 7 bankruptcy protection.  The bankruptcy trustee tried to get to the IRAs to pay the claims of creditors.  Several years of litigation followed.  The Eighth Circuit Court of Appeals found that the IRAs were savings accounts and were not protected from creditors.  The couple appealed to the Supreme Court.

Core requirements

To be protected from creditors, the couple's IRAs had to meet three requirements:

1.      The right to receive payment must be from a stock bonus, pension, profit sharing, annuity, or similar plan or contract;

2.      The right to receive payment must be “on account of illness, disability, death, age, or length of service;”

3.      The right to receive payment may be exempted only “to the extent” that it is “reasonably necessary to support” the account holder or his or her dependents.

In this case, the first two requirements were in dispute.

On account of age

The High Court first looked at the “on account of illness, disability, death, age, or length of service,” requirement.  In earlier rulings, the Court had interpreted the phrase “on account of” to mean “because of.” This interpretation requires a causal connection.  The couple's right to receive payment must be causally connected to one of the factors, such as disability, death or age.

The court found that the couple's right to receive payment was causally connected to their age.  If they withdraw their savings before age 59 1/2, they would pay a 10 percent penalty.  If they waited until after age 59 1/2, they would not pay a penalty.  The Court concluded that the penalty effectively limited the couple's right to payment of their IRA.  “Because this condition is removed when the account holder turns age 59 1/2, the couple's right to the balance of their IRAs is a right to payment “on account of age,” Justice Clarence Thomas wrote.

Comment: The Court noted that penalty-free distributions are permitted in special circumstances, for example, when taxpayers are first-time home buyers.  However, the court found that these exceptions would not change its ruling.  The couple could not obtain unrestricted use of their funds until age 59 1/2.

Similar plans or contracts

The Court next turned to the requirement that a right to payment must be from a stock bonus, pension, profit sharing, annuity, or similar plan or contract.  The couple's IRAs were clearly not stock bonus, pension, profit sharing, or annuity plans.  Instead, they argued that their IRAs were similar plans or contracts.

According to the taxpayers, their IRAs were similar to pension plans because they enable people to save for retirement.  The Court agreed.  IRAs, like stock bonus, pension, profit sharing and annuity plans, are not mere savings plans.  Instead, they provide a substitute for wages.

IRA owners must start receiving distributions when they turn 70 1/2.  At that age, taxpayers are likely to be retired and lack income from wages.  Money in an IRA also is taxed only when withdrawn.  This tax treatment encourages IRA owners to wait until retirement to withdraw their savings.  In addition, early withdraws are penalized.  All these characteristics, the Court concluded, show that IRA income is a substitute for wage income lost upon retirement and distinguish IRAs from “typical” savings accounts.

Caution: The Supreme Court's reasoning for protecting traditional IRAs does not make nearly as compelling a case for protecting Roth IRAs, since there is no tax or penalty on Roth IRA withdrawals up to the amount of after-tax contributions and no required distribution rules apply.  Even prior to the Supreme Court's decision, practitioners had questioned whether the same creditor protections under various state laws that applied to traditional IRAs also shielded Roth IRAs.  Fortunately, Roth IRAs (Code Sec.  408A) are specifically included in the statutory language of the pending bankruptcy bill's general IRA protections.  However, the general effective date of the bankruptcy bill is 180 days after enactment applicable to bankruptcy cases commenced only on or after that date.