Nugent Weinman - Are My Pension and IRA Assets Protected from Creditors?

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About the Author

John J. Abbene received a B.A., with high distinction from the University of Virginia in 1976, where he was elected to Phi Beta Kappa, and a J.D. from that school in 1979. Mr. Abbene is admitted to the Bars of the District of Columbia and Virginia, in addition to California. Mr. Abbene practices in the areas of corporations and business law, employee benefit and retirement plans and taxation and is a member of the State Bar of California section on taxation. He is also a member of the Western Pension and Benefits Conference.

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June, 2005

Are My Pension and IRA Assets Protected from Creditors?

By: John J. Abbene

The recently enacted Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Bankruptcy Act”) made significant changes in protecting an individual’s benefits held in qualified pension and profit sharing plans [including 401(k) plans] and individual retirement accounts (IRAs) in bankruptcy. This article discusses the creditor protection rules applicable to qualified plans and IRAs, both in bankruptcy and outside bankruptcy for California residents.

In 1992, the U.S. Supreme Court, in Patterson v. Shumate, held that a participant’s interest in an “ERISA-qualified pension plan” is excluded from that participant’s bankruptcy estate and, therefore, cannot be used to satisfy the claims of the participant’s creditors. A similar analysis in the non-bankruptcy arena leads to the conclusion that a creditor cannot reach a participant’s retirement benefits if the retirement plan is an “ERISA-qualified pension plan.” For the last 13 years, this term added confusion to any analysis since the term was not defined by the Supreme Court.

ERISA is a federal law that applies to employee benefit plans (pension plans and welfare plans) established or maintained by an employer or employee organization or both, excluding certain plans such as owner-only plans, government plans and church plans. Typically, a “qualified plan” is a pension plan, profit sharing plan (including a 401(k) plan), or stock bonus plan that satisfies certain requirements under the Internal Revenue Code (“IRC”). Although many “qualified plans” are “pension plans” covered by ERISA, whether or not the “qualified plan” is a “pension plan” as defined in ERISA is a completely independent analysis. In addition, ERISA covers many types of plans that are not qualified under the IRC and vice versa.

Bankruptcy

The Bankruptcy Act now makes it clear that an individual’s benefits held by (1) qualified pension and profit sharing plans (including 401(k) plans), whether or not covered by ERISA, (2) 403(b) plans, (3) 457 plans, and (4) subject to the limitation discussed below, IRAs (including traditional, Roth, SIMPLE or SEP IRAs,) are exempt from the bankruptcy estate. The exemption means that an individual’s benefits under the plans and IRAs are protected from the claims of creditors, both during and after the bankruptcy proceeding, except for federal tax liens. The Bankruptcy Act limits the exemption for traditional and Roth IRAs to $1,000,000. This limitation does not apply to rollovers from qualified plans and 403(b) plans or to SIMPLE IRAs or SEP IRAs. In addition, the exemption applies even if the state exemptions provide less protection.

In a bankruptcy situation, a debtor residing in California has the choice of applying one of two different sets of exemptions. One set of exemptions mirrors the exemptions provided under the Bankruptcy Code (“California bankruptcy exemptions”) and the other set of exemptions is the usual set of exemptions that applies in a non-bankruptcy situation in California (“California non-bankruptcy exemptions”). Although each set of exemptions treats retirement plans and IRAs differently, the new exemption applicable to retirement plan benefits contained in the Bankruptcy Act applies regardless of which set of exemptions the debtor elects. Therefore, other factors will dictate the debtor’s choice.

Non-Bankruptcy

In a non-bankruptcy setting, the California non-bankruptcy exemptions automatically apply except for ERISA plans and the exemption contained in the Bankruptcy Act is not relevant. ERISA is a federal law that supercedes or preempts any and all state laws that relate to any employee benefit plan. Therefore, in determining whether or not an individual’s pension or IRA benefits are protected from claims of creditors, it depends on the type of plan and whether or not the plan is covered by ERISA.

It is generally agreed that if the retirement plan is a pension plan covered by ERISA and meets the qualification requirements under the IRC, an individual’s benefits under the plan are protected from the claims of creditors. One exception is a Qualified Domestic Relations Order issued generally in a divorce situation and a second exception is a claim for taxes by the Internal Revenue Service. However, a qualified plan that covers only a sole proprietor (and his or her spouse), or the partners of a partnership (and spouses), or the sole owner of a corporation (and his or her spouse) is not an ERISA pension plan. Therefore, such “owner only” plans, most of which are qualified under the IRC, are not covered by ERISA and may not qualify for the creditor exemption described in Patterson v. Shumate.

For non-ERISA plans and IRAs (which are not subject to ERISA), creditor protection is available under Section 704.115 of California Code of Civil Procedure (one of the California non-bankruptcy exemptions). This Section provides that subject to certain exemptions, “all amounts held, controlled, or in process of distribution by a private retirement plan, for the payments of benefits as an annuity, pension, retirement allowance, disability payment or death benefit from a private retirement plan are exempt.” It also provides that “after payment, the [foregoing] amounts...and all contributions and interest thereon returned to any member of a private retirement plan are exempt.” Therefore, subject to certain exceptions described below, all benefits held in a private retirement plan and all distributions from a private retirement plan are exempt from creditor claims.

The Section describes a private retirement plan to mean: (a) private retirement plans, (b) profit sharing plans designed and used for retirement purposes, and (c) self-employed retirement plans and individual retirement annuities or accounts (IRAs). However, the exemption for self-employed retirement plans and IRAs ((c) above) only applies to the extent amounts in the plan or IRA are necessary to provide for the support of the debtor after retirement and for the support of the debtor's dependents, taking into account all resources that are likely to be available for such support when the debtor retires. As a result, when examining whether or not IRAs or benefits in a self-employed retirement plan are exempt for creditors, the court will make a facts and circumstances analysis looking at the amount of the debt, the amount in the plan or IRA, the age of the debtor, the debtor's earning capacity, the debtor’s other assets, the debtor’s ability to replenish the amount in the plan or IRA before retirement and other similar factors.

Conclusion

Although the new exemption for qualified plans and IRAs contained in the Bankruptcy Act means that an individual's benefits under the plans are generally protected from the claims of creditors, both during and after the bankruptcy proceeding, subject to the $1,000,000 limitation for certain IRAs and the exception for federal tax liens, creditor protection for plans and IRAs in non-bankruptcy situations is governed by applicable federal and California law. In a non-bankruptcy situation (1) if the retirement plan is a pension plan covered by ERISA and meets the qualification requirements under the IRC, an individual's benefits under the plan will be protected from the claims of creditors; and (2) if the plan is not covered by ERISA but meets the definition of a “private retirement plan” under Section 704.115 of the California Code of Civil Procedure, an individual’s benefits will be exempt from the claims of creditors unless the plan is a self-employed retirement plan or IRA (including a rollover IRA), in which case benefits will be exempt only to the extent necessary for the support of the debtor and the debtor’s dependents at retirement.