The pending bankruptcy reform legislation provides an exemption for IRA assets from the bankruptcy estate.² Both bills also exclude from the bankruptcy estate assets contained in an Education IRA.³

The justification for this preferential treatment appears to be based on Patterson v. Shumate, 504 U.S. 753 (1992), which first confirmed that an "ERISA-qualified plan" was completely excluded from the bankruptcy estate based on the anti-alienation provisions contained in ERISA. However, since IRAs are not encompassed by ERISA, they were not afforded protection under Shumate.⁴ Accordingly, Congress has deemed it necessary to act, but the legislation is a misguided erosion of the bankruptcy estate.

Background

In Shumate, the U.S. Supreme Court confronted the relationship between ERISA and bankruptcy law. Under §541(c)(2) of the Bankruptcy Code, an exclusion is available for debtor property that is subject to a restriction on transfer under "applicable non-bankruptcy law." The scope of this phrase had been the subject of constant debate among the circuits, with many courts concluding that the term was limited only to state law. The Supreme Court disagreed. In concluding that the plain language of the statute encompassed any non-bankruptcy law, the court held that the anti-alienation provision⁵ contained in ERISA-shielded pension assets from inclusion in the debtor's bankruptcy estate.⁶

The Bankruptcy Code also grants an exemption to any debtor's right to receive "a payment under a stock bonus, pension, profit-sharing, annuity or similar plan or contract...to the extent reasonably necessary for the support of the debtor and any dependent of the debtor."⁷ This exemption covers plans established by governmental entities and churches not covered by Title I of ERISA, and thus is not unnecessarily duplicative in light of Shumate. Both the exclusion and the exemption provide extensive protections for retirement plan assets held by the debtor, but do not provide clear protection for IRAs.

Congress clearly wants to extend similar protections to IRAs. However, the current legislation is excessive and will result in abuses by debtors. Pursuant to the legislation, debtors will be permitted to exempt up to $1 million contained in a traditional and/or Roth IRA.⁸ This exemption is inconsistent with the historical purpose of bankruptcy exemptions. Exemptions are intended only to "to protect a debtor from his creditors, to provide him with the basic necessities of life so that even if his creditors levy on all of his non-exempt property, the debtor will not be left destitute and a public charge."⁹ The current legislation provides much more than a minimum level of subsistence for the debtor, and effectively authorizes debtors to shield large sums of money from the valid claims of creditors.

Bankruptcy Reform Legislation

The bankruptcy reform legislation expands the protection currently afforded to ERISA pension plans to traditional IRAs, Roth IRAs and Education IRAs. First, with respect to traditional and Roth IRAs, the legislation grants an exemption to those accounts that have received a favorable determination pursuant to Internal Revenue Code §7805.¹⁰ In the event the IRA has not received a favorable determination, the assets will be exempt if the debtor demonstrates that no prior unfavorable determination has been made, and the IRA is in substantial compliance with the applicable provisions of the Internal Revenue Code.¹¹ If the IRA is not in substantial compliance with applicable law, the debtor may still claim an exemption if the debtor is not materially responsible for such failure.¹²

The legislation also provides that some contributions to Education IRAs are excluded from the bankruptcy estate.¹³ Generally, amounts contributed to an Education IRA within one year of filing will be excluded if (1) the designated beneficiary is a child, stepchild, grandchild or step-grandchild of the debtor, (2) the funds are not pledged or promised to an entity in connection with the extension of credit, and (3) the contributions are not excess contributions under Internal Revenue Code §4973(e) (in 2001, an excess contribution would be a contribution in excess of $2,000).¹⁴ For amounts contributed between 720 days and 365 days of the filing date, a $5,000 cap applies for purposes of the exclusion.¹⁵

Practical Analysis

The current legislation would afford a debtor an annual income of nearly $90,000 during retirement funded solely from assets shielded in a traditional or Roth IRA.¹⁶ Retirement is not an entitlement, and individuals who default on their financial obligations should not be afforded a luxurious lifestyle during their later years.

It is even more troubling that amounts shielded in IRAs would not necessarily have to be devoted toward retirement. Any individual may access his IRA assets at any time for any purpose if he is willing to pay a 10 percent penalty on amounts distributed prior to the date he attains age 59.¹⁷ In addition, there are several instances in which a penalty is not assessed, such as where the distributee receives a series of substantially equal payments made not less frequently than annually over the life (or life expectancy) of the IRA owner or the joint lives (or joint life expectancies) of the IRA owner and the IRA owner's designated beneficiary.¹⁸ First-time homebuyers may also use up to $10,000 of IRA funds toward qualified acquisition costs of a principal residence.¹⁹ The penalty also does not apply to distributions used to pay certain medical expenses, as well as health insurance premiums for those who have separated from employment.²⁰ Distributions may also be used to pay qualified higher-education expenses furnished to the IRA owner, his spouse or any child or grandchild of the IRA owner or his spouse.²¹

The case for exempting large amounts of Roth IRA assets from the bankruptcy estate is equally unpersuasive. The 10 percent penalty for early withdrawals applies only to the earnings portion of any Roth IRA distribution, as opposed to the entire amount of the distribution in the case of a traditional IRA.²² In other words, a Roth IRA owner may withdraw any non-rollover contributions from the account at any time for any reason without penalty regardless of age. Distributions from Roth IRAs may also be received without penalty if the owner is a first-time homebuyer who uses the funds to purchase a principal residence.²³

Finally, the protection afforded to Education IRAs by the legislation is perplexing.²⁴ The legislation grants an explicit exclusion, not merely an exemption, for Education IRAs. Not even ERISA pension plans receive an explicit exclusion under the statute. ERISA pension plans are excluded from the bankruptcy estate only as the result of anti-alienation requirements imposed by ERISA, and not because of any obvious determination by the drafters. Second, by creating a safe harbor for certain transfers made within one year of filing, the legislation practically encourages individuals to engage in fraudulent conveyances. Any contributed amounts that satisfy the safe harbor will be completely excluded from the bankruptcy estate, and thus will not be subject to the fraudulent conveyance prohibition in §548.²⁵ Third, and most confusing, the legislation creates a safe harbor for funds contributed between 720 days and 365 days before the filing date.²⁶ It is unclear why a safe harbor is necessary. Section 548 applies only with respect to fraudulent conveyances made within one year of the filing date. Accordingly, it seems that the only recourse for a creditor would be a fraudulent transfer claim under state law, which is unlikely to be successful.

Conclusion

Although some federal bankruptcy protection for IRAs may be appropriate, the current legislation goes too far in protecting debtors at the expense of creditors. Congress should rethink these provisions and strike a balance that better recognizes the rights of creditors.

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Footnotes

¹ The author is a tax attorney with Bose McKinney & Evans LLP in Indianapolis. He received his LL.M. in taxation from New York University Law School in 1999. The author wishes to thank Jim Carlberg and Jeannette Hinshaw for their contributions to this article. The views expressed herein are not necessarily those of Bose McKinney & Evans LLP. Return to article

² S. 420, 107th Cong., 1st Sess. §224 (2001); H.R. 333, 107th Cong., 1st Sess. §224 (2001). These exemptions will apply in the 14 states in which debtors may claim federal exemptions. Return to article

³ S. 420 §225; H.R. 333 §225. Return to article

⁴ Some states currently provide protections for IRAs pursuant to their own exemption schemes. However, debtors who elect to use the federal exemptions are not eligible to receive the state protections. Return to article

⁵ 29 U.S.C. §1056(d)(1). Return to article

⁶ 504 U.S. at 760. Return to article

⁷ 11 U.S.C. §522(d)(10)(E). Return to article

⁸ S. 420 §224(e); H.R. 333 §224(e). Return to article

⁹ H.R. Rep. No. 95-595, 126. Return to article

¹⁰ S. 420 §224(a); H.R. 333 §224(a). Return to article

¹¹ Id. Return to article

¹² Id. Return to article

¹³ S. 420 §225; H.R. 333 §225. Return to article

¹⁴ Id. Return to article

¹⁵ Id. Return to article

¹⁶ This calculation is based on the following assumptions: (1) an initial account balance of $1 million at age 65, (2) an annual rate of return of 7.5 percent, and (3) a life expectancy of 25 years. The average monthly payouts would be $7,398.34. Return to article

¹⁷ 26 U.S.C. §72(t). Return to article

¹⁸ 26 U.S.C. §72(t)(2). Return to article

¹⁹ Id. Return to article

²⁰ Id. Return to article

²¹ Id. Return to article

²² 26 U.S.C. §72(t)(1). Return to article

²³ 26 U.S.C. §72(t)(2). Return to article

²⁴ The legislation contains similar rules with respect to §529 plans. Return to article

²⁵ Contributions to an Education IRA made on behalf of a beneficiary within one year of filing would not necessarily constitute a fraudulent conveyance if there was no intent to defraud creditors and the provisions of §548 were otherwise satisfied. Return to article

²⁶ S. 420 §225(a); H.R. 333 §225(a). Return to article