Executive Summary: Recent changes in federal bankruptcy law provide new protection to owners of IRAs who file for personal bankruptcy. Under the new rules, IRA assets that have been rolled over from a tax-qualified plan are generally not subject to the claims of the IRA owner's creditors, regardless of the state in which the IRA owner resides or the value of the IRA.

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

Recently enacted legislation affords significant new protection to owners of IRAs who file for personal bankruptcy.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("Act") provides, with some exceptions, that the assets held in an individual's IRA are beyond the reach of that individual's creditors in the event the individual files for personal bankruptcy.

Specifically, the relevant provisions of the Act, which become effective with respect to bankruptcy cases commenced on or after October 17, 2005, provide that up to $1 million of funds and earnings thereon held in an IRA, or a larger amount determined by the bankruptcy court, are exempt from the IRA owner's bankruptcy estate. Funds held in a "simple" retirement account, a simplified employee pension (SEP), and assets that were "rolled over" to the IRA from a qualified plan or another IRA are disregarded for purposes of this $1 million limit. Stated differently, the portion of the IRA that is attributable to assets "rolled over" from a tax-qualified plan and earnings on those rolled over assets - typically all or a very large portion of the IRA assets - are protected even if those assets exceed $1 million. This new exemption applies without regard to (i) the state in which the IRA owner resides, (ii) whether that state has "opted out" of the federal bankruptcy exemptions and (iii) whether the IRA owner, in his/her bankruptcy filing, has elected to rely on the federal bankruptcy exemptions or the applicable state bankruptcy exemptions.

Significance of New Law

Prior to the enactment of the Act, it was not clear whether an individual's IRA would be exempt from claims of the individual's creditors in the event the individual filed for personal bankruptcy. A confusing mix of federal and state laws and court cases frequently meant that an individual did not know whether his/her "rollover" IRA - frequently consisting entirely of amounts rolled over from a tax-qualified plan and earnings on that amount and often representing the individual's single most valuable asset - would be subject to claims of creditors in the event the individual filed for personal bankruptcy. This uncertainty has often resulted in significant administrative expense and inefficiencies relating to retirement plan matters.

For example, physicians who sold their practice to a university-related practice group and wanted to continue to "self-direct" the investment of their retirement plan assets have been required to either (1) retain their professional corporation and its retirement plan (notwithstanding the significant expense of doing so) in order to keep their assets in a "qualified plan," where they historically have been exempt from bankruptcy-related claims, or (2) roll over their retirement plan assets to an IRA and run the risk that those assets would be subject to the claims of creditors in the event of a subsequent bankruptcy due to, e.g., a malpractice claim not adequately covered by the physician's malpractice insurance. Similarly, an executive of a company that is being sold or liquidated might be forced to roll over his/her substantial 401(k)/profit sharing account balance to an IRA and thereby lose the very broad bankruptcy-related protection long applicable to assets in employer-sponsored, tax-qualified retirement plans.

The new statute fully protects, for the first time, these rollover IRA assets against creditor claims, regardless of the state in which the IRA owner lives and regardless of whether the IRA owner has elected to rely on the federal or state bankruptcy exemptions.

Individuals who until now have left their retirement plan assets in their former employer's qualified retirement plan because doing so protected those assets, in the event of a subsequent bankruptcy filing, more effectively than if those assets had been rolled over to an IRA should re-consider the issue and decide whether rolling over those assets to an IRA now makes sense. Employees contemplating retirement or other termination of employment may now proceed to roll over their assets to an IRA without incurring the risk that a subsequent bankruptcy filing might make those assets subject to the claims of creditors.

Other Employee Benefit Provisions of New Law

The new legislation includes a number of other provisions relating to employee benefit plans, including:

  • Providing employees with additional protection from creditors with respect to employee contributions to plans that have been withheld from an employee's wages or paid by the employee but have not been transferred to the plan before the employee commences a bankruptcy action.
  • Facilitating an employee's repayment of plan loans after the employee has commenced a bankruptcy action.
  • Limiting the payment of retention bonuses and severance benefits to key employees and directors unless such payments satisfy strict requirements relating to the amount and reasonableness of such bonuses and severance payments.
  • Limiting an employer debtor's ability to modify its retiree benefits plan in the 180-day period prior to the debtor commencing a bankruptcy case.

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