Take-Away: Confusion reigns whether an inherited 401(k) account is exempt from inclusion in a bankrupt’s estate. It may all turn on timing of when the petition for bankruptcy is filed.

Background: As I mentioned in a recent Breakfast Briefing, Michigan is currently looking at amending its exempt property statute to add to IRAs inherited IRAs as exempt assets, to shield those enumerated assets from creditor claims.

While the U.S. Supreme Court has held that inherited IRAs are not exempt if the inheritor later files for bankruptcy, see Clark v. Ramer, 573 U.S. 122 (2014), lower courts still struggle with what inherited retirement accounts are, or are not, protected when the inheritor later files for bankruptcy.

Clark Decision: The U.S. Supreme Court held in Clark that an inherited IRA would not be protected, or treated as exempt from a bankrupt’s estate, unlike a traditional IRA, because of the different characteristics of an inherited IRA. The Court distinguished an inherited IRA(unprotected)  from a traditional IRA (protected) because the holder of the inherited IRA:

(i) may not contribute additional funds to the account; while income taxes can be deferred for a period of time, the purpose of the inherited IRA is not to incent contributions over time to save toward retirement;

(ii) is required to withdraw funds from the account, [then at least annually, now after the SECURE Act, no later than 10 years after the IRA account owner’s death] no matter how old he/she may be and no matter how many years away from retirement; and

(iii) withdraw the funds at any time without penalty prior to age 59 1/2.

The Clark Court observed: “..nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Court’s purposes of preserving the debtor’s ability to meet their basic needs and ensuring that they have a ‘fresh start’ into a ‘free pass.’ We decline to read the ‘retirement funds’ provision in that manner….’Retirement funds’ implies that the funds are currently in an account set aside for retirement, not that they were set aside for that purpose at some prior date by an entirely different person.”

When the Supreme Court speaks, usually that tends to settle things once and for all. That appears not to be the case, however, when it comes to inherited retirement plans in bankruptcy.

Kizer Decision: In re Kizer, Debtor, 539 B.R. 31674 (E.D. Mich.,S.Division 2015) the debtor who had filed for bankruptcy protection had been awarded an interest in three of his former spouse’s ERISA qualified retirement accounts. QDROs had been entered by the divorce court with regard to all three accounts dividing them with the debtor. The question was whether the debtor, as the alternate payee under the QDRO, could claim his interests in the awarded assets as ‘retirement accounts’ that are generally exempt in bankruptcy proceedings. One QDRO had been accepted by the plan administrator at the time the bankruptcy petition had been filed, while other other QDROs had not yet been formally accepted. The Bankruptcy judge applied Clark’s analysis, finding that the alternate payee could not contribute additional funds to the accounts, and he could withdraw the funds awarded to him under the QDRO without a 10% penalty for taking withdrawals prior to age 59 1/2. With this finding, the judge found that the funds held in the ERISA plans, subject to the QDROs, were part of the debtor’s bankruptcy estate and used to pay outstanding creditor claims.

Lerbakken: In re Lerbakken, 949 F.3d 432 (8th Cir. 2020) pretty much adopted the same legal analysis applied in Clark and Kizer, to find that the debtor’s entitlement to assets as an alternate payee in ERISA qualified plans of a former spouse did not make his interest in those plans ‘retirement accounts’ since he could not contribute additional funds to the qualified plan and he would not be subject to a 10% penalty upon taking any withdrawals from his share of the former spouse’s account. Accordingly,  the debtor’s interest in the qualified plans as an alternate payee under a QDRO, did not make his interests in those plans ‘an interest in a retirement plan’ for bankruptcy exemption purposes.

Dockins: But now we have a different result in In re Dockins, No. 20-10119, 2021 Bankruptcy. LEXIS 1516 (W.D.N.C., released June 4, 2021.) 

– Facts: In this decision a QDRO with regard to a qualified plan between divorcing spouses was not involved. Rather, a former boyfriend, Kirk, named his girlfriend, Holly, as the designated beneficiary of his employer-sponsored 401(k) account. Kirk died in February, of 2020. Holly learned to her surprise that Kirk had named her as his designated beneficiary in March, when the plan administrator contacted her to inform her of that fact. Holly (and her new husband) filed for Chapter 7 bankruptcy in April, 2020. At the time of her bankruptcy filing, Holly had not yet provided to the plan administrator any information or documentation, e.g. Kirk’s death certificate, as required by the plan administrator. That information was not furnished by Holly until May. The plan administrator then notified Holly that an account would be opened in her name under the plan, and it gave her instructions on how to go about accessing the funds in the inherited 401(k) account. The amount to be transferred to Holly’s was about $35,400. Six months later, Holly was informed by the plan administrator that she would have to take a full distribution of the amount held in her account no later than December 31, 2025.

Issue: The bankruptcy trustee claimed the amount that Holly inherited in Kirk’s 401(k) account was a non-exempt asset, citing Clark, and available to be used to pay her outstanding creditors. Holly responded that the inherited 401(k) account was not an asset of the bankruptcy estate.

Bankruptcy Judge: The judge found that the analysis in Clark, which had been followed in both Kizer and Lerbakken, was inapplicable to these facts. The judge relied on the fact that the funds were held in an ERISA-qualified plan on the date that Holly’s bankruptcy petition was filed.

ERISA. Spendthrift Limitation: As a result of that timing, the funds held in the 401(k) account were then subject to ERISA’s spendthrift limitations, and to the plan administrator’s control and fiduciary duties. Consequently, because the assets had neither been distributed to Holly, nor rolled over by her to an inherited IRA on the date that she filed for bankruptcy, the judge held that Holly’s inherited 401(k) account was not part of her bankruptcy estate.

Patterson:  As legal support for his conclusion, the bankruptcy judge relied on a much earlier Supreme Court decision that broadly interpreted the creditor protection afforded to qualified retirement plans under 11 U.S.C. Section 541(c)(2) and Patterson v. Shumate, 504 U.S. 753 (1992), the so-called antialienation provisions of ERISA.

– “However, a review of the relevant legal authorities, including statutory language of the Bankruptcy Code, the reasoning in Patterson, and the relevant case law, all support analyzing the inherited 401(k) under Section 541(c)(2) as in Patterson and under under an exemption analysis under Section 522(b)(3)(C) as in Clark…..Clark focuses on the meaning of ‘retirement funds’ under Section 522(b)(3)(C) and whether or not the funds were ‘set aside for the day an individual stops working.’ On the other hand, Section 541(c)(2) makes no mention of the term ‘retirement funds.’ The pertinent language of the statute is whether or not there is a transfer restriction ‘enforceable under applicable nonbankruptcy law.’ See Section 541(c)(2). As already noted, all 401(k) plans contain such transfer restrictions, and transfer by inheritance does not remove the restriction.”

Conclusion: Obviously, if Holly had rolled the balance of Kirk’s 401(k) account to an inherited IRA prior to the time that she filed for bankruptcy protection, it would have fallen squarely within the Clark fact-pattern and the inherited funds would not have been protected in her bankruptcy proceeding. Unclear is whether Dockins is consistent with Kizer or Lerbakken where some QDROs were accepted by plan administrators and other QDROs had not yet been accepted by the plan administrator at the time the bankruptcy petition was filed, where the funds were held inside a qualified plan governed by ERISA. If the funds are held in the qualified plan at the time the bankruptcy petition is filed, still within the control of the plan administrator, does ERISA’s antialienation provision trump the Supreme Court’s analysis that the funds are no longer held a ‘retirement account?’