Retirement Benefits Planning Update

Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome
information and suggestions from readers.

Bankruptcy Exemptions

As discussed in the previous column, certain retirement benefits do not generally qualify for exclusion from a debtor-participant’s bankruptcy estate under the United States Bankruptcy Code § 541(c)(2). These include plans not subject to Title I of ERISA (such as Keogh plans that do not benefit common law employees and nonqualified deferred compensation plans), government plans, IRAs and amounts that have been distributed from ERISA qualified plans to a participant before the filing of a bankruptcy petition. Such includable benefits may be removed from the bankruptcy estate, in whole or in part, if the participant is able to claim either (1) the federal exemption or (2) a state law exemption. Bankruptcy Code § 522(b). A majority of state laws “opt out” of the federal exemption under Bankruptcy Code § 522(b)(1), restricting persons domiciled in those states to the state law exemption.

The Federal Exemption

The federal exemption applies to a payment under a stock bonus, pension, profit sharing, annuity or similar plan or contract on account of illness, disability, death, age or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor. Bankruptcy Code § 522(d)(10)(E). The phrase “similar plan or contract” has been expansively interpreted by a majority of bankruptcy courts to encompass IRAs (in most states), tax-sheltered annuities and nonqualified plans. Bankruptcy Code § 522(d)(10)(E) expressly denies an exemption for nonqualified plan participants who are related to sponsors of plans providing payments on account of age or service. Even in states in which a participant may choose the federal exemption, the state exemption is usually selected because the relief available under the federal exemption is restricted by narrow and disparate judicial interpretations of the statute.

First, the federal exemption may apply only to plan payments that the participant has an immediate and present right to receive rather than to the participant’s account or interest in the plan. This judicial construction complements the Bankruptcy Code’s exclusion of undistributed qualified plan benefits and treats plan and IRA benefits includable in the bankruptcy estate similarly to other streams of payments (Social Security benefits, veteran’s benefits, disability payments and alimony) exempted by Bankruptcy Code § 522(d)(10). Vellis v. Karlanis, 949 F.2d 78 (3d Cir. 1991); In re Dale, 252 B.R. 430 (Bankr. W.D. Mich. 2000).

Second, some courts deny an exemption for IRA benefits because a participant’s immediate access to benefits is held to be inconsistent with the statute’s requirement that the exempted payments must be received on account of age or length of service. In re Zott, 225 B.R. 160 (Bankr. E.D. Mich. 1998). Other courts hold that immediate access to benefits must exist to satisfy the statutory requirement that the plan payments be reasonably necessary for the participant’s support. In re Carmichael, 100 F.2d 375 (5th Cir. 1996).

Finally, exempted payments that are reasonably necessary for the participant’s support include only the amount needed to sustain basic needs (rather than the maintenance of lifestyle at the time the bankruptcy petition was filed) and take into account the participant’s age, employability and income from other sources. In re Rector, 134 B.R. 611 (Bankr. W.D. Mich. 1991). As a result, amounts exempted by bankruptcy courts under the federal exemption are typically parsimonious.

State Law Exemptions

The state law exemption applies to any property that is exempt under state or local law applicable on the date of the bankruptcy petition filing. The law of the state in which the debtor’s domicile has been located for the 180 days immediately preceding the date of the filing of the petition (or for a longer portion of such 180 day period than any other state) controls. Bankruptcy Code § 522(b)(2)(A). State exemption laws relating to amounts that have been distributed from qualified plans before the filing of the petition, IRAs and non ERISA plans tend to follow the pattern of the federal exemption. These statutes raise state law interpretive questions similar to federal exemption issues, such as whether the entire plan or IRA interest or only payments being made at the time of filing are exempted, whether the plan or IRA is a “retirement plan” intended to make distributions on account of age or length of service or is merely a tax favored investment, and whether the amount involved is reasonably necessary for the participant’s support. Some states exempt amounts distributed from qualified plans before the filing of a petition if their origin is clearly traceable. Several states provide an unlimited exemption for IRAs (at least those funded by deductible participant contributions or by a rollover from a qualified plan). Other states limit IRA exemptions to a specified dollar amount, impose support criteria or exclude amounts contributed during a specified prefiling period.

Keogh plans and nonqualified plans, if exempted under state laws, may be required to be tax qualified under Code § 401(a) and, in the case of IRAs, the requirements of Code § 408 may have to be met. Bankruptcy courts differ as to the deference to be given to IRS determination letters and whether evidence of nonqualification may be introduced to refute qualified status. Compare In re Youngblood, 29 F.3d 225 (5th Cir. 1994) (deference given), to In re Morten, 188 B.R. 444 (Bankr. M.D. Fl. 1995) (no deference given).

Pending Legislation

The “Bankruptcy Abuse Prevention and Consumer Protection Act of 2001” (H.R. 333), if enacted in the form passed by the Judiciary Committee of the House of Representatives, would change IRA and Keogh plan protections. Whether a participant elects the federal or the state exemption, the Act would specifically exempt retirement funds to the extent that those funds are in a fund or account exempt from taxation under Code §§ 401, 403, 408, 408A, 414, 457 or 501(a). A fund or account is presumed to be tax-exempt if it has received a favorable determination letter and, unless an adverse letter has been issued, will be deemed to be tax-exempt (without a letter) if the fund is shown to be in substantial compliance with Internal Revenue Code rules (or if the participant is not responsible for its failure to comply). A million dollar cap, adjusted for Consumer Price Index increases, would apply to the exemption for a participant’s IRA accounts, whether traditional, Roth or rollover IRAs. The method of determining applicable state law for state exemptions would be tightened to apply the law of the single state in which the participant was domiciled for the 730 day period before filing (or, if none, to apply the current 180 day rule based on the participant’s domicile before the 730 day period).

Planning Considerations

The rollover of a conduit IRA for which no state exemption exists back into an excludable qualified plan (or the withdrawal of nonexempt IRA or plan benefits for investment in exempt property) may involve considerable risk unless made before the participant’s creditor obligations are incurred. A bankruptcy court may deny a discharge of the debtor’s indebtedness (rather then merely avoid the exemption) under Bankruptcy Code § 727(a)(2). Although the legislative history of Bankruptcy Code § 522 clearly states that a debtor’s conversion of nonexempt property into exempt property before filing a bankruptcy petition is not fraudulent as to creditors per se, a conversion undertaken with actual intent to hinder, delay or defraud any existing creditors may be set aside. A trustee in bankruptcy may avoid a transfer made within one year of the date of filing that has indicia of fraud (elusive criteria such as a “pattern of sharp dealing,” a large amount of exemptions or the misleading of a specific creditor) under Bankruptcy Code § 548(a)(1). Hansen v. First National Bank, 848 F.2d 866 (8th Cir. 1988). Transfers made before the one year period may be avoided by the bankruptcy court based on state fraudulent transfer laws under Bankruptcy Code § 544(b).

Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Joslyn Keydel & Wallace, LLP, Albert Kahn Building, 9th Floor, 7430 Second Ave., Detroit, MI 48202-2717,


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