Take-Away: As a generalization, IRAs are exempt when the IRA owner files for bankruptcy. In the past, we have noted an exception when the IRA was acquired by the debtor through a divorce settlement, where it was the former spouse, not the debtor, who had made the contributions to the IRA. As indicated in a recent Bankruptcy Court opinion, the question of exempt IRA assets in a bankruptcy proceeding is now a hot topic and Bankruptcy Trustees are becoming more aggressive in their assertions that the debtor’s IRA is not exempt in bankruptcy proceedings.

Case: In re Jones, 123 AFTR2d 2019-620 (Bank. Ct. S.D. Illinois, April 15, 2019)

Facts: [This could only happen in America!] Richard struggled to pay his debts. As Richard reached the conclusion that he probably would need to file for bankruptcy to discharge his debts, he devised one last, desperate, strategy. Buy lottery tickets! Richard withdrew $50,000 from his IRA [which, as noted, is an exempt asset in bankruptcy.] Richard deposited $49,000 of the withdrawn funds into his checking account; he used the remaining $1,000 to purchase lottery tickets. Over the next several weeks Richard used that checking account to purchase additional lottery tickets; these purchases were made on various dates and in various amounts, as part of Richard’s well-conceived ‘plan’ to win the Illinois lottery, pay his debts, and thus avoid the necessity to file for bankruptcy. [This reminds me of the old saying “Hope, or luck, is not a plan.” Sorry, I digress.] Needless to say, Richard’s strategy was unsuccessful- he spent $30,000 in the purchase of lottery tickets over several weeks. Richard also incurred $9,000 in state and federal income taxes associated with his $50,000 IRA distribution, including the 10% penalty for Richard’s premature withdrawal from his IRA prior to age 59 1/2. However, Richard did, within the 60 days after he withdrew the $50,000, redeposit in his IRA $20,000. A few months later Richard filed Chapter 7 Bankruptcy, in which he claimed that the $20,000 held in his IRA was an exempt asset under the federal Bankruptcy Code.

Richard’s Argument: Richard argued that the withdrawn IRA funds were reinvested in his IRA within the 60-day rollover period that is allowed by the IRA Regulations. [IRC 408(d) (3) (D).] Therefore, the $20,000 was entitled to be treated as an exempt asset and not available to the Trustee to pay Richard’s creditors.

Bankruptcy Trustee Arguments:

Commingled/Tracing: The Bankruptcy Trustee claimed that the funds that Richard withdrew from his IRA, and which were commingled with his other funds in the checking account, lost their exempt status once they were outside of the IRA. The Bankruptcy Trustee also claimed that the same $20,000 dollars originally in the IRA were not redeposited in the IRA by Richard- the $20,000 could not be traced to the amount originally withdrawn from the IRA.

Personal Benefit: The Bankruptcy Trustee alluded to another reason why the IRA’s $20,000 should no longer be exempt. Whenever an IRA owner withdraws funds and personally benefits from those withdrawn funds during the 60-day rollover period, the entire IRA should lose its exempt status.

Bankruptcy Court:

The Bankruptcy Judge noted that the Bankruptcy Trustee has the burden of proof that a debtor’s exemption is not properly claimed. The Trustee did not meet this burden of proof.

Key to the Judge’s decision is that at the time Richard filed for bankruptcy, he had re-deposited $20,000 in his IRA, so that the funds were in the IRA at the time bankruptcy relief was sought.

The Judge also found that there is no law that supports the proposition that the same money that came out of the IRA must be used for the ‘rollover’ back into an IRA within the 60-days. The Regulations provide with regard to a 60-day rollover that the money that was distributed from the IRA needs to be paid back “from the same amount of money and any other property.” [Reg. 1.408-4(b).] In short, there is no tracing

Similarly, according to the Judge, what happens to the money during that 60-day period is irrelevant as long as it is repaid to the same or a different qualified account before the 60th

Michigan: Like Illinois, and almost all other states, Michigan’s exempt property statute protects IRAs from a creditor’s levy and execution. Unlike the federal bankruptcy statute’s exemption, which imposes a dollar limit on the IRA account that is exempt in bankruptcy proceedings (over $1.2 million); the Michigan exempt property statute does not impose a dollar limit on the amount of the IRA that is protected from creditors. There are, however, three situations in which the Michigan statutory exemption will not protect an IRA: (i) the IRA is subject to a court order pursuant to a judgment of divorce; (ii) the IRA is subject to a court order that concerns child support; and (iii) contributions to the IRA in the tax year made or paid, exceed the deductible amount that could be contributed to the IRA, i.e. after-tax contributions are not protected [but this last exception does not apply to rollovers from qualified plans or 403(b) accounts to the IRA, which will continue to be protected.] [MCL 600.6023(j).]

Conclusion: Had Richard abandoned his foolhardy ‘plan’ to gamble his way out of debt, he would have left bankruptcy with $30,000 more assets for his retirement. As Americans accumulate more wealth in their IRAs, expect there will be even greater attention in the years to come to the federal and state exemption laws that pertain to IRAs.