Inherited 401(k) Accounts in Bankruptcy

Take-Away: A recent Bankruptcy Court decision added more confusion to whether an inherited 401(k) account is protected if the inheritor files for bankruptcy

Background: I have regularly complained (probably to anyone who will listen to me) that the current tax code and its Regulations with regard to contributions to and distributions from the various types of retirement savings accounts [IRA, Roth IRA, SEP IRA, SIMPLE IRA, 401(k), profit sharing, money purchase pensions, 403(b) annuity, 457 deferred compensation] are entirely too complex and disparate for a mere mortal to understand, often leading to traps, penalties and forfeitures. It appears that this obfuscation and resulting confusion is now working its way to the area of creditor rights with respect to the debtor’s retirement account.

A Short History of Creditor Protection for Retirement Accounts:

Bankruptcy:  When an individual files for bankruptcy, all property included in the bankrupt’s estate can be reached by creditors, except for certain property that is exempted from the bankrupt’s estate. [Bank. Code, 541.] Another section of the Bankrutpcy Code identifies items that, while technically part of the bankrupt’s estate, can still be exempted. [Bank. Code, 522.] Among the listed items are retirement funds, including IRAs, SEP and SIMPLE IRAs, 401(k), 403(b) and 457(b) plans.

– Limited Dollar Amount: For IRAs and Roth IRAs, but not SEP or SIMPLE IRAs, bankruptcy protection is limited to a dollar amount that is adjusted for inflation every 3 years. That amount in 2021 is $1,362,800. 

– Qualified Plans: The amount held in a qualified retirement plan, e.g. 401(k) account, is 100% exempt and maintains its 100% protection from creditor claims in bankruptcy. Even if a qualified plan account balance is rolled out of the qualified plan and into an IRA, it remains 100% protected, which is why it is a good idea to not commingle the rollover qualified plan funds with an existing IRA which faces a dollar amount limit of protection.

ERISA: ERISA also provides creditor and bankruptcy protection to a qualified retirement account, but not all, through its anti-alienation provision. Solo 401(k) plans Thrift Savings Plans, and some 403(b) and 457(b) plans are not ERISA-covered plans.

– Exception: The only statutory exceptions to ERISA anti-alienation protection is for qualified domestic relations orders [QDROs] and IRS tax levies.

– IRAs: Since Individual retirement accounts (IRAs) are not covered by ERISA, the IRA owner cannot benefit from the ERISA anti-alienation creditor protection.

– Supreme Court: The Supreme Court has had two occasions to address the scope of ERISA’s anti-alienation protection. In Patterson v. Shumate, 504 U.S. 753 (1992) the Court held that an ERISA plan participant’s account balance and benefits are excluded from his or her bankruptcy estate. [Bank. Code, 541(c)(2).] Yet in Clark v. Remakes 573 U.S. 122 (2014) the Court held that an inherited IRA is part of the inheritor’s bankruptcy estate, is not exempt, and thus can be reached by the inheritor’s creditors; the Court reached this conclusion when it found that the inherited IRA is not retirement funds.

What’s Protected in Bankruptcy? A couple of recent Bankruptcy Court decisions, previously reported in these missives, have only added to the confusion.

– Lerbakken v. Sieloff, No. 18-3415 (8th Cir. 2020): In this case, a former spouse was awarded part of his ex-spouse’s IRA and her 401(k) account as part of the divorce settlement. Part of the 401(k) account was assigned to the former husband via a QDRO. The former husband later filed for bankrutpcy and sought to exempt the divorce transferred IRA and 401(k) amounts from his bankruptcy estate, arguing that both the IRA and 401(k) accounts would have been protected if his wife had filed for bankruptcy, and that he essentially ‘stood in her shoes.’ Both the Bankruptcy Court and the 8th Circuit Court of Appeals disagreed, following the reasoning in Clark that neither account was the ex-husband’s retirement funds, and therefore not exempt from his bankrutpcy estate, i.e. he did not make the contributions for himself; only his former spouse made the contributions for herself.

– In re: Dockins, No. 2010119 (Bank.W.D.N.C., June 4, 2021): This was the case where a single man named his then-girlfriend, Holly, as the beneficiary of his 401(k) account at work. The man died suddenly with $45,411 in his 401(k) account. When the plan administrator located the Holly and told her about being named as the decedent’s designated beneficiary, the very next day, before the funds had been transferred out of the decedent’s 401(k) account, Holly and new husband filed for bankruptcy. They did not report the inherited 401(k) account to the Bankruptcy Court. Holly claimed that the inherited 401(k) account was outside the bankruptcy estate relying upon the Patterson decision. The bankruptcy trustee argued that Clark applied and that the inherited 401(k) account was not a retirement fund as described by the Supreme Court. The Bankrutpcy Judge held for Holly because: (i) the 401(k) plan was a qualified plan, not an IRA, and thus it was protected by ERISA’s anti-alienation provision; (ii) Patterson  not Clark applied; and (iii) the legislative history to ERISA makes it clear that when Congress adopted ERISA it intended to protect “interests of participants in employee benefit plans and their beneficiaries….” In short, the legislative history of ERISA clearly intended to shield beneficiaries from creditors was just as important to Congress as shielding participants from them. However, the Bankrutpcy Judge also made it clear that this protection would be lost if the inherited 401(k) account had the funds withdrawn before Holly had filed for bankruptcy protection. Because Holly’s inherited 401(k) account had not yet been distributed when she filed for bankruptcy, the inherited 401(k) account was beyond the reach of her creditors- timing is everything!

Practical Thoughts: When dealing with IRAs and qualified plan accounts, and concerns about creditor claims, consider the following:

1. Plan Rollovers: As noted earlier, an unlimited amount of qualified plan assets are protected from creditor claims, or if the participant files for bankruptcy. IRAs are treated different with a dollar amount limit of protection. While the qualified plan benefits if rolled over to an IRA from the plan are fully protected, if they are added to and commingled with a pre-existing traditional IRA, taking the balance of the IRA above the $1,362,800 amount, the IRA owner will have the burden to show how much of that balance came from the former qualified plan account- leading to time, expense, delays, and the task of ‘tracing assets.’ It would be much easer to roll the qualified plan assets to an entirely separate traditional IRA and avoid commingling the two sources of retirement funds.
2. Inherited IRAs: If an IRA owner is concerned about their intended beneficiary’s creditors, the Clarkdecision should compel the owner to name a see-throughtrust as the designated beneficiary of their IRA. While the SECURE Act generally will force the inherited IRA to be emptied within 10 years, the see-through trust’s spendthrift clause will protect the inherited IRA from being included in the trust beneficiary’s bankruptcy proceeding
3. Inherited 401(k) Accounts: Inheritors need to be aware of the different bankruptcy creditor protections afforded inherited IRAs and inherited ERISA plan account balances and not confuse the two. As the Dockinsdecision suggests, if bankruptcy is being contemplated by the inheritor, it is far better to file for bankruptcy protection first, before pulling the funds out of the qualified plan account and into a rollover IRA. However, some qualified plans might not permit the non-employee inheritor to either maintain an account within the qualified plan, or the plan might not let the account assets linger too long inside the plan before mandating a distribution from the ERISA protected qualified plan.
4. Divorce Divided Retirement Accounts: If spouses are getting a divorce, and the non-owner spouse has creditor problems (which is often the reason why the spouses are getting a divorce), negotiating for a division of the owner-spouse’s traditional or Roth IRA, or a division of their 401(k) account through the use of a QDRO may not provide to them the creditor protection they might think they will be entitled to receive. See Lerbakken. Strange as it may sound, an irrevocable discretionary trust with spendthrift provisionsfor the spouse with creditor problems might be a better solution, so long as all of the assets used to fund that discretionary trust are the owner-spouse’s separate property.
5. Michigan Exempt Property Statute: Michigan’s exempt property statute exempts the owner’s traditional IRA and Roth IRA from creditor claims. [Federal ERISA law protects the owner’s qualified plan accounts from creditor claims.] However, the Michigan statute, as it presently is written, does not protect inherited IRAs. A bill is currently being studied in Lansing that would extend exempt property protection to inherited IRAs (even though under Clarkthe inherited IRA would not be protected if the inheritor later filed for bankruptcy.)

Conclusion: While Congress may not be able to agree on any new tax law legislation (or even the time of day for that matter!) maybe it could come to some sort of bipartisan agreement on  legislation to simplify retirement account contribution limits, penalty-free retirement plan distributions, and perhaps extend ERISA and Bankruptcy Code creditor protection to IRAs to make IRAs comparable with qualified plan accounts when it comes to protecting retirement accounts from creditor claims. With so many different rules depending upon the type of plan, or depending upon where ERISA protection starts and stops, there are far to many traps for individuals (and their advisors) to fall into these days.