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George F. Bearup, J.D. Senior Legal Trust Advisor

4-Jan-19

Qualified Plans and the Loss of Creditor Protection

Take-Away: A few months ago a Bankruptcy Court decision was brought to your attention where a former spouse who received part of his wife’s IRA as a result of their divorce settlement, divided pursuant to IRC 408(d), lost that IRA in a subsequent bankruptcy proceeding, where the debtor’s post-divorce IRA was not treated as an exempt asset. [Lerbakken v. Sieloff and Associates, 8th Circuit Panel.] A similar loss of creditor protection can apply to the debtor’s interest in a qualified plan account that is divided in a divorce using a qualified domestic relations order (QDRO.)

Case: In re Kizer, Debtor, 539 B.R. 31674, Collier Bankr. Cas. 2d 105 (E.D. Mich. S. Div, 2015).

Facts: The debtor was awarded an interest in three of his ex-wife’s qualified plan retirement accounts. Each of those retirement accounts were divided between the spouses incident to their divorce using qualified domestic relations orders (QDROs.) One of the QDROs had been accepted by the plan administrator, while another QDRO with regard to another qualified plan account had not been formally accepted by its plan administrator prior to the former husband filing for bankruptcy.

Issue: The central issue was whether the debtor, as the alternate payee under the QDROs, could claim that the retirement benefits awarded to him in the divorce action were exempt ‘retirement funds’ under the federal Bankruptcy Code?

Court: The Bankruptcy judge held that these divided qualified plan retirement assets, awarded to the debtor subject to the QDROs, were not exempt in the debtor’s bankruptcy proceeding as they were not retirement funds.

  • Rameker Decision: The Bankruptcy judge referred to the U.S. Supreme Court’s decision in Clark v. Rameker, 573 US 122 (2014), which held that an inherited IRA was not exempt in the inheritor’s subsequent bankruptcy proceeding. Specifically, the Rameker decision focused on 3 characteristics of an inherited IRA that would not enable it to be eligible for the retirement funds exemption most qualified plan accounts and IRAs have in a bankruptcy proceeding. Those three Rameker characteristics which lead to the conclusion the divorce-divided retirement accounts are not exempt retirement funds in bankruptcy are:
  • No Contributions: The beneficiary of an inherited IRA cannot contribute additional funds to that inherited IRA. Thus, even though the inherited IRA can defer taxable withdrawals (thus permitting growth inside the inherited IRA) the purpose of an inherited IRA is not to incentivize contributions over an extended period of time in order to save towards retirement;
  • RMDs: The beneficiary of an inherited IRA is required to withdraw funds annually under the required minimum distribution rules, no matter the beneficiary’s age or how many years must pass before they retire; and
  • No Penalties: The beneficiary of an inherited IRA may withdraw funds from the inherited IRA without any penalties, prior to attaining age 59 ½, unlike the owner of the traditional IRA who must pay those penalties.

The Bankruptcy judge applied the Rameker characteristics to the debtor’s interests in the qualified plans under the 3 QDROs. The judge found that (i) under the qualified plan, the debtor as alternate payee, could not contribute additional funds to those qualified plan accounts which were assigned to him-he was not a participant in the plan; and (ii) the alternate payee could withdraw the funds awarded to him under the QDROs without the imposition of the 10% penalty for a premature withdrawal of funds prior to attaining age 59 ½.

While the judge noted that annual withdrawals were not required to be taken from the divided qualified plan accounts- presuming the debtor rolled his share of his former spouse’s qualified plan accounts into his own IRA where he would not have to take distributions prior to attaining age 70 ½, all three Rameker characteristics did not need to be present in order to disqualify the debtor’s share of the divided qualified plan accounts from being treated as a retirement fund. Nor did the judge distinguish the accounts where one QDRO had been approved by the plan administrator, while the other QDRO was still pending acceptance from its plan administrator.

Questions:

  1. Would the outcome be the same if the debtor had rolled his share of his former spouse’s qualified plan accounts into a traditional IRA, where he would then be subject to the 10% penalty for an early withdrawal and there were no required minimum distributions, and to which he could make future contributions from his own earnings? While logic would suggest that the rolled funds into a traditional IRA would be protected, the Lerbakken suggests that even the rolled funds would not be protected, since those funds did not originate from the debtor’s own contributions from his own earnings.
  2. If the federal bankruptcy courts are prepared to split hairs when it comes to exempting retirement funds, one wonders if state courts will follow the lead of the federal courts, and find that an IRA held by a former spouse, where the source of the contributions is not the owner of the IRA but a former spouse, is not protected under Michigan’s statutory creditor exemption for IRAs.

Conclusion: The participant in a qualified plan will have his/her account balances exempt in a future bankruptcy proceeding as they are clearly retirement funds. A former spouse who receives a portion of those qualified plan account balances under a QDRO will not have those assets protected in a subsequent bankruptcy proceeding. Even if the funds assigned under the QDRO are subsequently rolled into a traditional IRA they will probably not be protected either since they did not originate from the debtor’s own earnings. Who contributed the funds to the retirement account, either qualified plan or IRA, tends to drive the answer if the funds will be treated as retirement funds for bankruptcy protection purposes, it would be a good idea for the debtor spouse to never commingle the assigned IRA or QDRO awarded assets with the debtor’s own IRA account where its contributions can clearly be traced back to the debtor.