Take-Away: The use of an IRA as collateral security for a loan could cause that IRA to become immediately taxed as income. A borrower needs to be careful when listing an IRA on the schedule of assets furnished to a lender.

Background: The Tax Code generally forbids the use of any portion of an IRA as security for a loan. If such a pledge occurs, the portion (or whole) of the IRA ceases to be treated as an IRA and the entire IRA will be deemed a taxable distribution. [IRC 4975(e)(4).]

Michigan Protection: Michigan, by statute, protects traditional and Roth IRAs from creditor claims. [MCL 600.5451(1); MCL 600.6023(1)(k).] Note, however, that that an IRA is not an ERISA qualifed plan, so that ERISA’s ‘spendthrift’ protections do not apply to IRAs. In short, the creditor protection to IRAs is afforded by state exemption statutes, while the federal ERISA laws protect qualified plan accounts.

A recent case from Florida demonstrates the danger of listing an IRA on a schedule of the borrower’s assets.

Case: Kearney Construction LLC v Travelers Casualty & Surety Company of America, 2019 WL 5957361 (Fla 11th Cir App, November 13, 2019.)

Facts: The debtor, Bing Kearney (Bing) obtained a line-of-credit from Moose Investmens of Tampa, LLC (Moose.) Bing pledged collateral as security for this 2012 line-of-credit. Bing submitted an affidavit along with the signed Pledge Agreement; on Bing’s asset affidavit was his IRA held at US AmeriBank.  Moose’s standard Pledge Agreement that Bing signed included the following language:

As security for any and all indebtedness, Pledgor irrevocably and unconditionally grants a security interest in the collateral described: all assets and rights of the Pledgor, wherever located, whether now or hereafter acquired.”

Bing defaulted on the line-of-credit and Moose (or its assignee) claimed the right to Bing’s assets, including his IRA.

[Reading about Bing and Moose made me feel like I was reading an old Archie comic book!]

Issue: The obvious issue was whether Bing intended to include his IRA as collateral security for the line-of-credit.

Bing’s Arguments: Bing had a pretty good argument why his IRA should not be exposed to satisfy the judgment arising from the defaulted line-of-credit. Like Michigan, Florida has a statute that makes a debtor’s IRA exempt from creditor claims. Therefore, despite the broad language used in Moose’s Pledge Agreement, Bing’s IRA should not be within the scope of that Pledge Agreement. Bing also argued that unlike other assets covered by the Pledge Agreement, his IRA was never ‘delivered’ to Moose and therefore Moose’s security interest in the IRA was never ‘perfected.”

Trial Court: The District Court in Florida found that Bing’s IRA was included within the scope of the Pledge Agreement, since Bing’s affidavit was incorporated by reference into that Agreement. The trial court glossed over the argument that Moose’s security interest in Bing’s IRA was never perfected, and it applied a very narrow interpretation to the scope of Florida’s IRA creditor exemption statute.

Appellate Court: The Appeals Court sustained the trial judge’s decision that Bing’s IRA was available to satisfy the judgment against Bing. In reaching its decision, this Court provided some troubling observations:

Public Policy: Creditor exemption statutes are usually intended to be liberally construed as they are a reflection of the state’s public policy to protect individuals. This liberal interpretation is intended to protect the debtor so that the debtor, and his or her family, will not become a public charges of the state. This protective public policy is also reflected in the federal Bankruptcy Code, which also extends protection [over $1.2 million] to a bankrupt’s IRAs. For whatever reason, this Court did not provide a liberal or expansive interpretation to Florida’s IRA exemption statute to carry out, or at least reflect, Florida’s presumed public policy behind exempting IRAs from satisfying a debtor’s judgment.

Waiver: On the more technical question, this Court found that Bing had waived his right to assert the protection of Florida’s IRA exemption statute when he listed his IRA on the affidavit that accompanied the signed Pledge Agreement.

The Court pointed to the broadly phrased language in Moose’s Pledge Agreement to conclude that Bing waived his rights to assert the Florida IRA exemption statute. Implicitly, had Bing not listed his IRA in his affidavit, presumably it would continue to have been protected by the Florida statute.

What is somewhat troubling is that normally when statutory rights are being waived, the individual’s waiver must be ‘knowing, voluntary, and intelligent.’ This higher standard is applied in order to discourage routine waivers of important rights.  It is hard to believe that Bing’s execution of a lender’s ‘boilerplate’ Pledge Agreement constituted his knowing and intentional waiver of his statutory rights to have his IRA exempted from creditor claims.

Conclusion: Hopefully the Florida Supreme Court will be asked to overturn this surprising decision. Florida’s IRA exemption statute is much like Michigan’s and we do not want this case as some type of precedent to narrow the protection afforded by Michigan’s IRA exemption statute.

If possible, an IRA should never be listed by a borrower as an asset that is available as collateral security for a loan of any kind.

In this situation, not only did Bing lose the statutory protection to his IRA , he also now has the obligation to pay income taxes [and a 10% early distribution penalty?] on the claimed IRA.