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Retirements Benefits Planning Update
Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman PC, The Buhl Building, 535 Griswold, Suite 1900, Detroit, MI 48226–3679, firstname.lastname@example.org.
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.
New Bankruptcy Rules for IRAs and Retirement Plans
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Pub. L. No. 109–8, 119 Stat. 23, referred to herein as BAPA) was signed by the President on April 20, 2005, and generally applies to bankruptcy petitions filed on or after October 17, 2005. BAPA expands, modernizes, and greatly clarifies the U.S. Bankruptcy Code protections that apply to a debtor’s retirement arrangements by adopting a broad federal exemption for retirement funds. The new exemption applies to a variety of retirement arrangements, including IRAs and nontrustee plans such as Code § 403(b) tax-sheltered annuities, regardless of whether a debtor chooses to exempt other property from the bankruptcy estate under the state and local law exemptions or, if permitted, under the federal bankruptcy law exemptions. Although the new federal exemption may restrict even more favorable state exemptions (for example, by imposing a $1 million cap on the exemption for IRAs to the extent funded by annual account owner contributions), the new law resolves numerous interpretive quandaries and eliminates what most commentators would view as artificial distinctions between the forms of retirement plans that have evolved over the years.
Current Law Exclusion
As described in the January/February 2001 “Retirement Benefits Planning Update” column, all of a debtor’s legal and equitable interests in property are included in the debtor’s bankruptcy estate unless specifically excluded. Bankruptcy Code § 541(c)(2) provides for the exclusion of a debtor’s interest in a trust if there is “[a] restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law.” In Patterson v. Shumate, 504 U.S. 753 (1992), the Supreme Court held that ERISA is an “applicable nonbankruptcy law.” Thus, pre-BAPA law excludes a debtor’s interest in a trusteed pension, profit-sharing, and stock bonus plan that is subject to ERISA, although courts differ on whether the plan involved must be income tax qualified under the Internal Revenue Code for the exclusion to apply.
Plans that are not subject to Title 1 of ERISA, including Code § 457 plans of tax-exempt employers or governmental units, some Code § 403(b) plans, IRAs (and SEPs and SIMPLEs), Keogh plans that do not benefit common law employees, and nonqualified deferred compensation plans, can be excluded from a debtor’s bankruptcy estate only if (1) the debtor’s interest can be said to be in a trust, (2) an applicable nonbankruptcy law other than ERISA (a state law) is determined to restrict the beneficial interest of the debtor, and (3) if applicable, the court is willing to disregard the debtor’s immediate access to the benefits. The recognition of the exclusion for non-ERISA plans has been sporadic. Certain jurisdictions determined the exclusion to be available, based on specific state statutes and specific plan provisions, for IRAs ( In re Yuhas, 104 F.3d 612 (3d Cir. 1997), cert. denied, 521 U.S. 1105 (1997), and In re Robert P. Davis, 108 Fed. Appx. 717 (3d Cir. 2004), setting forth five criteria for exclusion)), for Keogh plans ( In re Moses, 167 F.3d 470 (9th Cir. 1999)), for Code § 403(b) annuities ( In re Barnes, 264 B.R. 415 (Bankr. E.D. Mich. 2001)), and for Code § 457 plans ( In re Mueller, 256 B.R. 445 (Bankr. D. Md. 2000)).
The Bankruptcy Code § 541(c)(2) exclusion is unaffected by BAPA and will remain available. For tax-exempt plans, however, the new federal exemption will also effectively remove retirement benefits from the debtor’s estate and the exclusion will provide added protection, if at all, in only limited circumstances. For example, in those jurisdictions in which the income tax qualification of an ERISA plan is not required for the exclusion to apply (and the debtor is unable to demonstrate that the plan is exempt from taxation under the new federal exemption’s criteria described below), the exclusion may apply. In the unlikely case of an IRA that is large enough to exceed the federal exemption limit without having received significant rollovers from a tax-exempt plan, a debtor could avoid the limit if the elements for an exclusion could be established.
Current Federal and State Exemptions
The pre-BAPA federal exemption contained in Bankruptcy Code § 522(d)(10)(E) 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 depen-dent of the debtor. The Supreme Court recently resolved a conflict among the circuits by holding that the phrase “similar plan or contract” includes a traditional IRA and that the Code § 72(t) 10% early withdrawal tax that applies to distributions until age 591/2 is attained effectively limits the payment of IRA benefits to payments “on account of” age. Rousey v. Jacoway, 125 S. Ct. 1561 (2005). Although the federal exemption is relatively expansive in the kinds of benefits covered (including tax-sheltered annuities and certain nonqualified plans), the relief granted by the exemption is limited to payments that are reasonably necessary for the debtor’s support as determined by the bankruptcy court. As a result, even if the current federal exemption is available (that is, the debtor’s state of domicile is not one of the majority of states that have “opted out” of the federal exemption under Bankruptcy Code § 522(b)), debtors often elect to have the state and local law exemptions apply. The current federal exemption is not amended by BAPA but will be effectively superseded for tax-exempt retirement plans by the more expansive new federal exemption.
One of the immediately effective provisions of BAPA (section 307) changes the Bankruptcy Code § 522(b)(2)(A) rule for determining a debtor’s domicile for purposes of determining the state and local law that applies to exemptions. The former minimum domiciliary period of 180 days before the petition being filed is now extended to 730 days. If a debtor has not been domiciled in a single state for that 730-day period, the applicable state law is the law of the debtor’s domicile for the 180-day period preceding the 730-day period before filing (or the debtor’s domicile for the greatest number of days within such 180-day period). As described in the May/June 2001 “Retirement Benefits Planning Update” column, state law exemptions frequently follow the pattern of the current federal exemption, exempting only payments from IRAs and non-ERISA plans that are necessary for support, may impose dollar or percentage limits on the portion of a plan interest exempted, or may require that a plan be in pay status for the exemption to apply. In the case of tax-exempt retirement benefits covered by the new federal exemption, the decision of whether to elect either the federal exemption or the state exemptions for nonretirement properties will no longer be affected by the state exemptions for retirement benefits except to the extent that nonqualified deferred compensation arrangements are involved.
New Federal Exemption
BAPA § 224 amends Bankruptcy Code § 522 to provide for the exemption of that portion of a bankruptcy estate that consists of retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under
Code § 401—‑qualified pension, profit sharing, stock bonus plans including ESOPs, 401(k) plans, and Keogh plans (even those with no common law employee);
Code § 403—‑qualified annuity plans and tax-sheltered annuities and custodial accounts;
Code § 408—‑traditional IRAs (accounts and annuities), simplified employee pensions (SEPs), and savings incentive match plans for employers (SIMPLEs);
Code § 408A—‑Roth IRAs;
Code § 414—‑multi-employer plans and church plans;
Code § 457—‑deferred compensation plans of state or local governments or tax-exempt organizations; or
Code § 501(a)—‑tax-exempt organizations (including certain retirement trusts).
The new federal retirement funds exemption is available regardless whether, under Bankruptcy Code § 522(b), the debtor (1) elects to have the federal exemptions of Bankruptcy Code § 522(d) apply to other bankruptcy estate properties or (2) chooses (or, in an “opt out” state, is required to choose) to have the state and local exemptions of amended Bankruptcy Code § 522(b)(3) apply to other properties. The new exemption language is included in both amended Bankruptcy Code §§ 522(b)(3)(C) (state and local) and 522(d)(12) (federal) exemption sections of the amended Bankruptcy Code.
For purposes of determining whether the fund or account is exempt from taxation, it will be presumed that funds in a retirement plan that has a favorable determination letter under Code § 7805 that is in effect at the time the petition is filed is exempt from taxation. If a fund has no favorable determination letter, the funds will be exempt from the debtor’s bankruptcy estate if the debtor demonstrates that
• no prior determination to the contrary has been made by a court or the IRS and
• the retirement fund is in substantial compliance with Internal Revenue Code requirements (or, if not in substantial compliance, the debtor is not materially responsible for that failure). Amended Bankruptcy Code § 522(b)(4)(A) and (B).
Neither a direct trustee-to-trustee transfer nor a rollover of retirement funds from one of the enumerated funds or accounts to another enumerated fund or account will cause the funds to cease to qualify for the federal exemption. Amended Bankruptcy Code § 522(b)(4)(C) and (D).
IRA Exemption Cap and Rollovers
New Bankruptcy Code § 522(n) limits the exemption for the aggregate value of a debtor’s traditional IRAs and Roth IRAs (excluding SEPs or SIMPLEs) to $1 million, as adjusted for inflation, except that such exemption amount may be increased if the interests of justice so require. The exemption limit is computed without regard to IRA amounts attributable to rollover contributions, either via an eligible rollover distribution under Code § 402(c) deposited in a tax-exempt fund or account within 60 days or by a trustee-to-trustee transfer under Code § 401(a)(31), from any of the non-IRA tax-exempt plans or accounts described in the Internal Revenue Code sections listed in the federal exemption.
As a result of the protection of the full amount of rolled over retirement benefits by the federal exemption, the current reluctance to roll over qualified plan benefits to an IRA (for example, so as to obtain investment and dispositive flexibility) because the exclusion from the bankruptcy estate would be lost should no longer prevent rollovers. Note, however, that the federal exemption from a debtor’s bankruptcy estate does not provide creditor protection in a pre-bankruptcy setting, and, if potential creditor problems exist, state laws regarding creditors’ rights should be consulted before a rollover that will eliminate the spendthrift protections of an ERISA plan.
Additional BAPA Provisions
BAPA § 323 also amends Bankruptcy Code § 541(b) to add new subparagraph (7) that excludes from a debtor’s bankruptcy estate amounts withheld by an employer from wages of employees for payment to a plan subject to Title 1 of ERISA, a governmental plan under Code § 414(d), a Code § 457 plan, or a Code § 403(b) plan, as well as amounts received by an employer from an employee for payment as contributions to such a plan.
BAPA § 224 amends Bankruptcy Code § 523(a) by adding new subparagraph (18) that provides that no loan owed by a debtor participant to a plan established under Code §§ 401, 403, 408, 408A, 414, 457, or 501(c) shall be discharged in bankruptcy, thus preserving the retirement fund’s ability to collect any plan loan made to the debtor.
BAPA § 225 amends Bankruptcy Code § 541(b) to add new subparagraphs (5) and (6) that provide for the exclusion from a debtor’s bankruptcy estate of funds contained in a Coverdell education savings account under Code § 530 and funds used to purchase a tuition credit or certificate (or contained in an account) under a qualified state tuition program under Code § 529(b)(1)(A). The exemption applies to funds that were placed in the account (or program) at least one year before the filing of the petition (with the exemption for funds placed in the account for any one beneficiary not earlier than 720 days before filing but not later than 365 before filing being limited to $5,000). The individual benefited by the account or program must have been a child, stepchild, grandchild, or stepgrandchild of the debtor at the time funds were placed in the account or program. The exemption excludes amounts that exceed the maximum permissible contributions to the account or program, and, in the case of Coverdell accounts, such funds may not be pledged or promised to any entity in connection with any extension of credit.