26-Feb-20
Update – Retirement Accounts in Bankruptcy
Take Away: Month’s ago I reported on the Lerbakken Bankrutpcy Court decision where a debtor’s awarded interest in his former spouse’s retirement accounts was not protected in his subsequent bankruptcy proceeding. That decision was sustained by a federal appeals court earlier this month.
Case: Lerbakken v. Sielfoff & Associates, 590 BR 895122, A.F.T.R. 2d 2018-6359 2018-2 (Minn., 2018), affirmed Eighth Circuit Court of Appeals, February 7, 2020.
Background: The federal Banruptcy Code exempts from the debtor’s estate, which is used to pay their creditors, retirement funds. 11 U.S.C. 522(b)(3)(c).
Retirement Funds: What constitutes retirement funds was described in 2014 by the U.S. Supreme Court in Clark v. Rameker, 513 U.S. 122 (2014).
Inherited IRAs: In Clark, the question was whether an inherited IRA was an exempt asset when the beneficiary later filed for bankruptcy. The Supreme Court used a three step analysis to identify when assets are retirement funds and when inherited IRA funds are not retirement funds: (1) the beneficiary of the inherited IRA cannot contribute additional funds to the retirement account; (2) the beneficiary of the inherited IRA must take distributions from the IRA at least annually; and (3) the beneficiary of the inherited IRA can withdraw funds from the IRA at any time without any penalty. Because of these special rules that apply to an inherited IRA, the Court found that the assets in the inherited IRA do not constitute retirement funds that are protected in a subsequent bankruptcy proceeding.
Retirement Funds Incident to a Divorce: In another Bankruptcy Court decision, the three-factor Clark test was applied to find that retirement account assets received by the debtor incident to an earlier divorce were also not protected. In In re Kiser, Debtor, 539 B.R. 31764 (Mich. S. Div. 2015) a divorce court had entered 3 separate qualified domestic relations orders (QDROs) awarding a portion of a former spouse’s qualified plan accounts to their spouse who later filed for bankruptcy. As the alternate payee of those 3 QDROs the debtor could contribute no additional funds to the qualified plan accounts awarded to him, and he could withdraw the entire portion of the qualified plan account awarded to him without any penalty before he turned age 59 1/2 . Accordingly, the alternate payee-debtor’s portion of the qualified plan accounts were not protected as retirement funds in his subsequent bankruptcy proceeding. Note that some states have statutes that protect these divorce awarded retirement accounts from creditor claims, but those state statutes do not apply in a federal bankruptcy proceedings.
Question: One the the questions after both the Kiser and Lerbakken court decisions was what would have been the result if the former spouse, who had been awarded a part of their spouse’s IRA or qualified plan account [the situation in Lerbakken] had actually rolled the awarded assets into their own IRA- where they would have been able to (i) continue to make contributions; (ii) not be required to take annual distributions; and (iii) would be subject to the 10% penalty if they took a distribution prior to attaining age 59 1/2?
Lerbakken: The appellate court came close to answering this question that the awarded assets to the former spouse in his divorce were not, yet, retirement funds. The distinction was that the divorce court had given to Mr. Lerbakken’s divorce attorney a lien against both the IRA assets that were awarded to Mr. Lerbakken from his wife’s IRA account [IRC 408(d)] and also the portion of Mrs. Lerbakken’s 401(k) account that had been awarded to him under a QDRO. Because of that attorney’s lien, Mr. Lerbakken was obligated to use both the IRA and the 401(k) account assets to satisfy his divorce attorney debt. In effect, because these awarded retirement account assets were subject to the court imposed lien, they were regular assets under state divorce law until that claim was satisfied, at which point they could then be rolled over by Mr. Lerbakken into an IRA when, presumably, they would become retirement funds for federal bankruptcy law exemption purposes.
SECURE Act: The remaining question is the impact of the SECURE Act’s 10-year payout rule on the Supreme Court’s Clark ‘test’ that focuses on the requirement that the beneficiary of an inherited IRA must take annual distributions. With the SECURE Act, there is no obligation to take annual distributions from the inherited IRA until the 10th anniversary of the IRA owner’s death. While the SECURE Act eliminated the obligation to take annual distributions from an inherited IRA, there still exists the obligation to take the entire inherited IRA account balance by the tenth year, which does not exist with a regular IRA.
Conclusion: When the Clark decision was initially published, the perceived solution to protect inherited IRA assets from loss to creditors or in bankruptcy, was to make the IRA payable to an accumulation trust, where the trust’s spendthrift provision would protected the inherited retirement assets from creditor claims, or in the trust beneficiary’s subsequent bankruptcy filing. An accumulation trust may still work to protect inherited IRAs, but the SECURE Act’s 10-year payout requirement now poses a trade-off decision to be made: a higher income tax bill paid by the accumulation trust in exchange for the creditor protection it affords the inherited IRA.