How protected are your clients' retirement accounts after the 2005 Bankruptcy Act?

Much ink has been spilled on how the 2001 federal tax act may, or may not, mean the end of the traditional estate planning practice as we have known it. Come what may from Congress in the form of estate tax legislation, one thing that will probably not change is that estate planning lawyers need to know a little about a lot of things. While the estate planning specialist may not always feel comfortable giving advice to be relied upon by the client in any particular case, it will not do, in client conferences, always to say: "I am not an expert in that area; we will have to get (the client hears 'pay') my partner or outside counsel to answer that question."

Over the past several years, clients seem to be paying closer attention to asset preservation, especially their retirement accounts. Even clients with no known or foreseeable creditors want assurances that their retirement accounts are safe from the "frivolous" lawsuits they read about in the newspapers and hear about in political speeches. They want to know what is "safer": an employer-sponsored plan or an IRA? The wide publicity given to Congress' enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 on April 20, 2005, has served to heighten interest in these and other related areas. Clients want to know if Congress, having moved to slay the federal estate tax dragon, has acted again as St. George to dispatch predatory creditors.

This article takes stock of the relevant state and federal law as it existed before the act in order to better understand the changes wrought, and not wrought, by it. We will continue by discussing the provisions of the act relevant to the exemption of IRAs and other retirement accounts from creditors' claims in the context of a federal bankruptcy proceeding. In Florida, these changes cannot be understood apart from state law; as it happens, the relevant state statutes recently have been amended, and we will discuss these changes. The article will conclude by identifying areas where the act may not be clear, and where questions may remain. (1)

The One Thing to Know About Federal and State Law Exemptions

If a retirement account (2) owner voluntarily seeks the protection of federal bankruptcy laws, or is involuntarily put into bankruptcy by his or her creditors, (3) the extent to which his or her retirement accounts are exempt is determined by federal law. On the other hand, if the retirement account owner is sued in state court, state law exemptions apply.

Under federal bankruptcy laws, both before and after the act, a debtor-in-bankruptcy generally can choose between exemptions available under the federal Bankruptcy Code (set forth in 11 U.S.C. [section] 522(d)) and those available under the law of the state in which the debtor resides. Federal law, however, gives the states the ability to require debtors to use state law exemptions in a federal bankruptcy proceeding. Florida has done just that: F.S. [section] 222.20 provides that "residents of this state shall not be entitled to use the federal exemptions in [section] 522(d) of the Bankruptcy Code...." Thus, in Florida, whether the issue is to be resolved in the federal bankruptcy court or state court, the heart of the matter is Florida's state law exemptions, which are largely set forth in F.S. Ch. 222.

Protection for Retirement Accounts Before the Act

* Accounts in Qualified Plans

In many instances, the protection afforded to accounts in "qualified" retirement plans (by which we mean, generally speaking, employer-provided plans covered by ERISA's fiduciary rules, as contrasted, generally speaking, with IRAs) before the act, and before the revisions to F.S. [section] 222.21 discussed below, frequently turned on the subtleties of ERISA or on the court's (usually the bankruptcy court's, but never the Tax Court's) determination as to whether the account was income tax exempt. Beginning on October 17, 2005, when the relevant provisions of the act took effect, exemption of retirement accounts will be analyzed differently.

The seminal pre-act case is Patterson v. Shumate, 504 U.S. 753 (1992). In that case, the U. S. Supreme Court concluded that a debtor's interest in a pension plan subject to Part 2 of Title I of ERISA was excluded from the debtor's bankruptcy estate under 11 U.S.C. [section] 541(c)(2), which excludes from the estate any beneficial interest of the debtor in a trust subject to a restriction on transfer enforceable under any applicable nonbankruptcy law. The Court noted that plan was subject to [section] 206(d)(1) of ERISA (29 U.S.C. [section] 1056(d)(1)), which requires any ERISA-qualified plan to provide that benefits under the plan cannot be assigned or alienated. The Court reasoned that the ERISA spendthrift provision was a "restriction on transfer enforceable under applicable nonbankruptcy law."

The Patterson decision had its limits. First, it only applied to pension plans covered in Part 2 of Title 1 of ERISA. Plans that might otherwise be thought of as "qualified plans" that cover only owners of corporations and partnership, but not employees, are not covered by Part 2 of Title 1 of ERISA. These plans are not required to have the "ERISA spendthrift clause" that covered the plan at issue in Patterson. Thus, a debtor's interest in a plan that covered owners, but not employees, could not be exempted from the bankruptcy estate; the interest was included in the estate and could be protected only if an exemption was available.

Second, clever creditors' lawyers noted that the Court, when it concluded that an "ERISA-qualified" plan described in Part 2 of Title 1 of ERISA was excluded from the bankruptcy estate, never defined exactly what it meant by "ERISA-qualified." These lawyers reasoned that a plan could be "ERISA-qualified" only if it was also "tax-qualified," i.e., if it was exempt from federal income taxes under the Internal Revenue Code. Thus, if they could show that the plan was not entitled to a federal income tax exemption, they would be successful in including the debtor's interest in the plan in the bankruptcy estate. And, because F.S. [section] 222.21(2)(a) exempts for state law purposes (and, therefore, also for federal bankruptcy purposes) only those plans that are qualified under the Internal Revenue Code, inclusion of the "non-ERISA-qualified plan" in the debtor's bankruptcy estate necessarily would also mean that the included plan was not exempt.

Florida courts have been receptive to this line of reasoning and have held that, for a plan to be "ERISA-qualified" under Patterson, the plan must also be tax qualified. (4) Further, rejecting the argument that a bankruptcy court should defer to the IRS on the matter of the tax qualification of a retirement plan, Florida courts have permitted creditors to attack the tax-qualified status of a plan that never has been disqualified by the IRS. (5) Thus, a creditor who could convince a court that the plan was not tax qualified could assert its claims against the debtor's interest in such a plan.

* Accounts in IRAs

IRAs are not subject to the part of ERISA considered by the Court in Patterson; further, an IRA is not subject to an ERISA spendthrift provision. An IRA is, thus, not an "ERISA-qualified" plan under Patterson. However, under F.S. [section] 222.21(2)(a), both before and after its amendment, an IRA that is tax qualified under [section] 408 of the Internal Revenue Code (a traditional IRA) or [section] 408A of the Code (a Roth IRA) generally is exempt from creditors' claims both in federal bankruptcy proceedings and for state law purposes.

However, just as a creditor could attack the exemption of a qualified plan by showing that it was not income tax exempt, a creditor could attack the exempt status of an IRA de novo, even if the IRS had not done so. For example, if the creditor could show that the IRA owner had engaged in a prohibited transaction that could, under [section] 4975 of the Internal Revenue Code, cause the IRA to lose its tax exempt status, the creditor could attach the owner's IRA. (6) Similarly, if the creditor could convince the court that MegaBank operated its IRA program, in which the debtor owns an account, in a manner that would cause the program to lose its tax exempt status, the creditor could lay claim to the owner's IRA, even if the IRS had never questioned MegaBank's IRA program.

Given the wide publicity (and perhaps over-hyping) that the U. S. Supreme Court's decision in Rousey v. Jacoway, 1225 S. Ct. 1561 (2005), has received in the popular media, a nod in that direction is in order. In Rousey, the Court held that a debtor's interest in an IRA was exempt from creditors' claims under the Bankruptcy Code because an IRA is "similar" to stock bonus, pension, profit-sharing, and annuity plans, all of which are exempt from bankruptcy claims under the federal (and not state law) bankruptcy exemptions. Many have been led by the coverage of Rousey to conclude that all IRAs always are exempt from all creditors' claims, but they are wrong. The Court was clear that only that portion of the IRA that was reasonably necessary to support the IRA owner and his or her dependents is exempt. The degree to which the IRA was reasonably necessary for support was not before the Court and remains to be decided by the lower courts on a case-by-case basis.

Rousey was fated to be a shooting star. Little more than a week after the decision, the act effectively snuffed it out. The star never shone brightly in Florida anyway. A Florida debtor could not use the federal bankruptcy exemption for IRAs conferred by the Court in Rousey; debtors who are residents of this state must use the state law exemptions found in [section] 222.21(2)(a) in bankruptcy proceedings. And, that is a good thing if you are a debtor because the state law exemption is, at least until the act takes effect (see discussion below), not limited to what is reasonably necessary to support the owner and his or her dependents.

Protection for Retirement Accounts After the Act

* Federal Bankruptcy Law

The provisions in the act that affect retirement accounts generally took effect on October 17, 2005.

The act amends the Bankruptcy Code by providing that the following assets are exempt from the claims of bankruptcy creditors: "retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code." (Emphasis added.) 11 U.S.C. [subsection] 522(b)(3) and (d).

As noted above, creditors' lawyers have been successful in attacking qualified plans by arguing in the bankruptcy court that the plan was not tax exempt. Does the act's explicit linking of the plan's exemption with its tax exempt status amount to the start of hunting season? Congress has tried to keep the rifles on the rack. Section 522(b)(4) of the Bankruptcy Code, as added by the act, provides that, if a plan has received a favorable determination letter from the IRS, the plan funds "shall be presumed to be exempt from the [bankruptcy] estate." Even if there is no such letter and the presumption, therefore, cannot be invoked, the plan funds will be exempt if the debtor can show that the IRS previously has not determined that the plan is not in compliance and either that the plan is in substantial compliance or, if it is not, that the debtor was not materially responsible for that failure. This, Congress appears to have hoped, will make the chances of success in attacking a plan's tax exempt status much less likely, though not impossible, to succeed.

Three things about the expanded bankruptcy exemption for retirement accounts stand out. First, the new exemptions added by the act and set forth in new [subsection] 522(b)(3)(C) and 522(d)(12) are not available to debtors who are domiciled in Florida for federal bankruptcy purposes. As mentioned above, F.S. [section] 222.20 requires Florida debtors-in-bankruptcy to use Florida's state law exemptions, and the act's new exemptions are federal law exemptions. As noted below, however, this does not mean that Florida practitioners can ignore the act's new provisions.

Second, because the new exemptions for retirement accounts are explicitly tied to their exemption from taxation, Patterson's distinction between retirement accounts in qualified plans that are covered by an ERISA spendthrift clause and those that were not so covered are no longer analytically useful. Under the act, the Patterson exclusion has been replaced by an exemption that has the same practical effect for which the only inquiry is the tax classification of the plan or account.

Third, traditional IRAs and Roth IRAs are exempt from bankruptcy creditor claims, without regard to need, as long as they are tax exempt. A Rousey inquiry into the amount of the IRA that might be necessary to support the debtor and dependents no longer is necessary after the act takes effect.

There is an important qualification to the otherwise unlimited exemption the act provides to retirement accounts that may not prove to be very limiting in practice. There is another qualification, not a part of the act, but very much a part of the planning landscape.

The act's exemption for retirement accounts is limited to an aggregate value of an inflation-adjusted $1 million, "determined without regard to amounts attributable to rollover contributions ... and earnings thereon." 11 U.S.C. [section] 522(n). The $1 million ceiling has two very large holes in it. The limitation applies only to traditional and Roth IRAs. It does not apply to simple IRAs under [section] 401(p) of the Internal Revenue Code or to SEP IRAs under Code [section] 408(k), and it does not apply to qualified plans and 403(b) and 457 plans; in all these cases, the exemption under the Bankruptcy Code is unlimited. The cap also does not apply to amounts rolled over into a traditional or Roth IRA from another plan or account. And, amounts rolled over from one exempt plan to another will not lose their exempt status.

Thus, the cap would, as a practical matter, appear to apply almost exclusively to IRAs that a debtor establishes on his or her own with after-tax dollars. By one commentator's reckoning, if one had made the maximum allowable contributions to an IRA beginning in 1975 and ending with this year's contribution, the most that could have been contributed to the IRA would be $63,500. (7) Even with some robust assumptions about the appreciation in value of contributed amounts inside the IRA, it is unlikely that a private, non-rollover IRA would top the $1 million mark anytime soon.

The act made no changes to federal bankruptcy laws in this regard: Regardless of the type of the plan, any distributions made from the plan lose their protected status in the hands of the owner.

The act contains important provisions about 529 plans and education IRAs, which are not properly thought of as retirement accounts. Here, again, these are federal bankruptcy law exemptions not available to bankruptcy debtors who are Florida residents. The act excludes 529 plans from the bankruptcy estate, but only to the extent of funds lawfully contributed to the plan for the period ending one year before the filing of the petition; and an additional $5,000 as among all 529 plan accounts that had the same beneficiary during the period beginning 720 days before the petition date and ending one year before the petition date. 11 U.S.C. [section] 541(b)(6). The act also excludes educational IRAs from the bankruptcy estate, subject to the same limitations applicable to 529 plans (though the amount one can lawfully contribute to an educational IRA is usually lower than what can be contributed to a 529 plan). 11 U.S.C. [section] 541(b)(5). In both cases, the exemptions only apply if the plan beneficiary is a descendant or a step-descendant of the contributor.

* State Law

Perhaps the reader has skipped to this part of the article thinking that developments in federal bankruptcy laws do not apply to him or her since all of his or her clients live in Florida and cannot use the federal bankruptcy exemptions. However, it is not that simple.

Florida debtors, whether in bankruptcy or in state court, may avail themselves of a favorable array of state law exemptions for retirement accounts. Even prior to the amendments discussed below, F.S. [section] 222.21(2)(a) protected, without a dollar amount limitation, retirement funds in plans qualified under [subsection] 401, 403(b), 408, 408A, and 409 of the Internal Revenue Code. Effective June 1, 2005, the statute was amended to include church and governmental plans described in [subsection] 414, 457(b) and 501(a) of the Internal Revenue Code. Henceforth, these plans, too, will enjoy the protection of an unlimited statutory exemption.

In another instance of great minds seeming to think alike, the Florida Legislature, as Congress, has made it more difficult to challenge successfully the exempt status of a plan under Florida law on the theory that the plan is somehow not tax exempt. Effective June 1, 2005, a debtor's interest in a plan enumerated in [section] 222.21(2)(a) is exempt if 1) the plan has been maintained in accordance with a general master plan or governing instrument, the form and content of which has been pre-approved by the IRS, and the IRS has not determined that the general master plan or form of governing instrument is not tax exempt in an order that has become final and nonappealable; 2) the plan has been maintained in accordance with a particular plan or governing instrument that specifically has been determined by the IRS to be tax exempt, and the IRS has not determined that the specific general master plan or governing instrument is not tax exempt in an order that has become final and nonappealable; or 3) if the plan fails to satisfy either of the first two tests, if a preponderance of the evidence shows that the plan is in substantial compliance with the requirements for tax exemption, or, failing that, the reason for the failure substantially to comply is not due to the negligence or willful conduct of the debtor. Thus, a Florida debtor who must invoke state law exemptions under F.S. Ch. 222 has essentially the same level of protection from an argument that his plan is not protected because it is not tax exempt as a debtor who invokes the protection of the federal bankruptcy exemptions under the act.

Florida debtors also enjoy protection for 529 plans and educational IRAs that may be superior to that afforded debtors who must choose to use the federal bankruptcy exemptions. Section 222.22(1) has been amended, effective June 1, 2005, to exempt without limitation assets in 529 plans, including the Florida Prepaid College Trust Fund programs, from the claims of the creditors of both the owner and the beneficiary. Subsections 222.22(2) and (3) were amended to accomplish the same thing in the areas of health savings accounts and educational IRAs, respectively. Unlike federal law, the state law exemption is not limited to accounts established for descendants or step-descendants of the contributor.

And, as Florida debtors batten down for another hurricane, they can take some measure of solace from knowing that, when and if Congress ever authorizes the creation of "hurricane savings accounts," an amount in such an account equal to twice the amount of their homeowner's insurance deductibles will be exempt from the claims of their creditors. New subsection (4) was added to [section] 222.22 to so provide, but only if the account relates to homestead property.

Points for Further Reflection

It is tempting to suppose, as Florida lawyers, that knowledge of exempt assets needs only stretch far enough to include Florida's exemptions under Ch. 222. That may have been true before the act, but not anymore. Prior to the act, a debtor's domicile, for federal bankruptcy purposes, (8) was his or her domicile for the 180 days before the petition was filed. The act lengthens this period of residency to two years, and contains detailed provisions, outside the scope of this article, (9) to determine the domicile of a debtor who has not lived in the state of filing for more than two years. These provisions, designed to thwart forum shopping by debtors, are tricky to apply in practice, and can yield counter-intuitive results.

Many new Florida residents who have lived here for fewer than two years have concerns about how protected their IRAs will be in Florida. These concerns cannot be addressed simply by reference to Ch. 222. The advisor must at least have a passing familiarity with the act to advise someone who has come to Florida from a state whose law may not exempt IRAs from the claims of creditors but may permit the use of the federal bankruptcy exemptions. The Florida lawyer should be able to identify, though perhaps not resolve, such an issue.

Whenever state law and federal law intertwine, as they necessarily do for a Florida debtor in bankruptcy, questions about the supremacy of federal law over state law are bound to arise. And, they come up in the wake of the act, which, as discussed above, generally limits the amount of the exemption for non-rollover private IRAs to an aggregate of $1 million. The act is silent as to whether its limitation is intended to trump an unlimited exemption under state law. In the face of this silence, the answer is not clear; however, from an application of general principles of federalism, one could conclude that a Florida debtor in bankruptcy could protect only $1 million of funds in his or her IRA because that is the maximum allowed under federal law. Though the resolution of this issue may be academic given the small likelihood of a private IRA reaching an amount in excess of $1 million, the federalism issue may crop up again in the area of 529 plans and educational IRAs. Both enjoy an unlimited exemption, regardless of the identity of the beneficiary, under Florida law while the exemption is capped under the act. Do the federal cap and the limitations based on the identity of the beneficiary apply to a Florida debtor in bankruptcy who is using Florida state exemptions? The analysis should be the same as for IRAs.

Aside from the differences between state and federal law, other issues remain on a purely federal level. For example, several commentators have speculated as to whether an IRA will retain rollover character when rolled over from an IRA in the name of the deceased owner to the surviving spouse. Similarly, it does not seem clear whether inherited IRAs will retain the protection in the hands of nonspouse beneficiaries that they may have had for a deceased IRA owner. Some of these questions can only be answered by case law or further legislation.

Conclusion

An estate planning lawyer, like most lawyers, must be a specialist and something of a generalist at the same time. Increasing sensitivity on the part of many clients to the protection of their assets from creditors' claims requires that an estate planning specialist have at least a general familiarity with the changes in this area that have been brought about by the act and of the relationship between Florida's state law exemptions under F.S. Ch. 222 and federal bankruptcy law exemptions. However, a little knowledge can sometimes be a dangerous thing. Estate planning lawyers, armed with the ability to identify issues that the act touches on, will be well served to involve outside counsel if circumstances require. This article is intended, in part, to help the estate planner identify those circumstances.

(1) This article is written by two estate planning lawyers who profess no special expertise in federal bankruptcy law. It is intended to sensitize nonbankruptcy practitioners to the ways in which the new bankruptcy laws may influence the recommendations that estate planning lawyers make to their clients. It is not intended to be a substitute for the advice of qualified bankruptcy counsel, or of qualified counsel in other relevant areas, when circumstances warrant.

(2) Unless indicated to the contrary in the text, the term "retirement account" is used in its broad sense and refers to traditional and Roth IRAs, SEP-IRAs, simple IRAs, ERISA-qualified plans, government-sponsored plans, and the like.

(3) See discussion on these points in Nelson, How Does the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 Affect Florida Homestead? Many Unanswered Questions, in this issue of The Florida Bar Journal.

(4) See, e.g., In re Fernandez, 236 B. R. 483 (Bankr. M. D. Fla. 1999); In re Harris, 188 B. R. 144 (Bankr. M. D. Fla. 1995).

(5) See, e.g., In re Sutton, 272 B. R. 802 (Bankr. M. D. Fla 2002); In re Harris, 188 B. R. 144 (Bankr. M. D. Fla. 1995).

(6) See, e.g., In re Roberts 326 B. R. 424 (Bankr. S. D. Ohio 2004) (IRA owners pledge of IRA funds caused the IRA to lose its tax exempt status; funds were not exempt in bankruptcy).

(7) ED SLOTT'S IRA ADVISOR, June 2005.

(8) A debtor's domicile for federal bankruptcy purposes is a question of federal common law. See, e.g., In re Hodgson, 167 B. R. 945 (Bankr. D. Kan 1994).

(9) See Nelson, supra, note 3.

Richard R. Gans is a shareholder in the Sarasota firm of Fergeson, Skipper, Shaw, Keyser, Baron & Tirabassi, P.A. He is board certified in wills, trusts, and estates, a member of the Real Property, Probate and Trust Section's IRA & Employee Benefits and Asset Preservation committees, and a member and co-vice chair of the section's Estate and Trust Tax Planning Committee.

Kristen M. Lynch is an attorney in the Boca Raton firm of Elk, Bankier, Christu & Bakst LLP. She is a certified trust and financial advisor as well as a certified IRA services professional. Ms. Lynch is a member of the Real Property, Probate and Trust Section's Trust & Tax Planning and Asset Preservation committees, as well as chair of the IRA & Employee Benefits Committee. She is also a member of the Tax Section of The Florida Bar.

The authors thank Charles I. Nash, Melbourne, for his helpful insights.