Take-Away: While an IRA can be divided by spouses in a divorce without income tax consequences to the owner of the IRA, apparently there can be a loss of creditor protection to the former spouse who receives the IRA incident to a divorce.

Background: The division of traditional IRAs and qualified retirement accounts is common in divorces and has been for the past 30+ years.

  • Income Tax Consequences: The tax law is clear that retirement assets, whether they are held in a qualified plan like a 401(k) account, or a traditional IRA, can be divided with a former spouse without any income tax consequences to the owner of the retirement account or IRA. The qualified plan account can be divided with a qualified domestic relations order (QDRO) entered by the divorce court, or an IRA can be divided with a direct transfer of part of the IRA account to a new IRA account that is created by the former spouse to which the IRA funds are then directly transferred. [IRC 408(d).] Consequently, the income tax consequences of such transfers are clearly understood.
  • Creditor Protection Consequences: But what about creditor protection? Michigan has a statute that expressly protects IRAs from creditor claims, regardless of the amount held in the IRA. [MCL 600.6023(k).]The bankruptcy code protects IRAs and other retirement account assets including IRAs, but there is a dollar limit (adjusted annually by cost of living) that also protects a bankrupt individual’s IRA. That protected amount of IRA assets is now above $1.2 million.  The federal bankruptcy code provides exemption from the bankruptcy estate for: Retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Sections 410, 403, 408, 408A, 457 or 501(a) of the Internal Revenue Code of 1986. [11 U.S.C. 522 (d)(12)(2018).] Thus, it was thought that if one held an IRA or qualified plan account and later filed for bankruptcy, those retirement assets would be excluded from the bankrupt’s estate that is used to pay creditor claims. Even if the retirement assets came from a former spouse it was logically thought that they, too, were protected in bankruptcy, since those assets remained exempt from taxation in the hands of the former spouse.

Not So Fast, Says a Bankruptcy Appeals Panel: Sadly, when we invite courts to comment upon the law, often we find ourselves wondering when they lost their common sense. Such is the situation in In re Brian A. Lerbakken, No. 18-6018 filed October 16, 2018. In that decision a Bankruptcy Appellate Panel for the 8th Circuit [Minnesota] found that the IRA and 401(k) accounts that a husband had received in a divorce from his wife were not exempt when the husband later filed for bankruptcy.

  • “Retirement Funds:” The Appellate Panel found that for the federal bankruptcy exemption law to apply, two separate conditions had to be met: (i) the amount had to be retirement funds; and (ii) the retirement funds had to be held in an account that is exempt from taxation under one of the Code provisions cited above. Rice v. Allard (In re Rice), 478 B.R. 275, 280 (E.D. Mich. 2012). These conditions are not unreasonable.
  • Rameker Definition of “Retirement Funds:” But the Panel then applied the 2014 Supreme Court decision in Clark v. Rameker, 134 S. Ct. 2242, which you will recall found that an inherited IRA was not covered by the bankruptcy law exemption for a retirement account. The Rameker Court concluded that since the Bankruptcy Code did not define retirement funds, it would provide its own definition: ‘retirement funds’ is therefore properly understood to mean sums of money set aside for the day an individual stops working.
  • ‘Create and Contribute:’ From the Rameker definition of retirement funds the Bankruptcy Appellate Panel then concluded that the bankruptcy exemption is limited to individuals who create and contribute funds into a retirement account. “Retirement funds obtained or received by any other means do not meet this definition.” Since the husband in the divorce did not contribute his own IRA (it was part of the wife’s that was divided in the divorce) his post-IRA was not entitled to any exemption under the Bankruptcy Code. “Any interest he holds in the accounts resulted from nothing more than a property settlement.”
  • Marital Retirement Savings Rejected: The husband argued that while he and his wife were married, both he and his wife were saving for ‘their’ retirement, and the division of her retirement accounts upon their divorce was nothing more than a division of their mutual retirement savings (where his separate retirement savings was implicitly considered in the divorce). The Panel was unmoved by this argument. Instead,  it focused solely on who made the contributions to the retirement account. Since husband did not make contributions to wife’s IRA and 401(k) accounts, they were not considered by the Panel to be retirement accounts under the Bankruptcy Code, even if they continued with their tax-deferred status.
  • Result: Both husband’s IRA, as well as that part of his former wife’s 401(k) account that he received pursuant to a QDRO,  which funds were then rolled into his own IRA, were not exempt from creditor claims and were treated as a part of the husband’s bankruptcy estate.

Conclusion: The result in Lerbakken seems to grossly extend the logic of the  Supreme Court’s decision in Rameker. In Rameker, the inherited IRA was just one of many assets the designated beneficiary received on the death of the IRA owner. Yet the decision in Lerbakken ignores the reality of many marriages where spouses pool their funds, and often will intentionally make disparate contributions to retirement plans available to them due to matters beyond their control or choice. For example, suppose the wife in Lerbakken aggressively participated in her employer’s 401(k) plan contributing $15,500  annually because of the availability of a generous employer ‘matching’ contribution, while husband was self-employed and thus he only contributed to a traditional IRA with a $5,500 maximum annual contribution. Looking at their marriage as a unit (which divorce judges will do), they contributed $21,000 a year to their retirement plans, leaving that much less to pay bills e.g. mortgages, yet two-thirds of the retirement benefits were held under wife’s name. In a subsequent divorce, if those retirement assets were to be divided 50%-50% by the divorce court, some of wife’s retirement assets, whether IRA or 401(k), would have to be transferred to husband to equalize those marital retirement fund contributions. Lerbakken produces an illogical result: if the wife had been the party to file for bankruptcy, all of her retirement accounts would be fully exempt, while husband’s retirement accounts, which came exclusively from wife’s protected retirement assets will be lost in the payment of his creditors. Hopefully this judicial conclusion in Lerbakken is an outlier, but caution suggests that if an individual is contemplating a divorce with the probable shifting of retirement assets, this loss of creditor protection in a future bankruptcy needs to at least be mentioned, and possibly addressed in some manner in the divorce judgment, e.g. reserving a spousal support award if one spouse loses his/her retirement assets in a future bankruptcy proceeding. Lerbakken will be a big surprise to divorce attorneys around the country, not to mention their clients.