Keeping A Slice Of The Pie For Yourself: Exempting IRAs, 401Ks And 529 Plans

When a debtor files for bankruptcy relief, an estate is created. 11 U.S.C. §541(a)[1] provides that the estate consists of all legal and equitable interests of the debtor in property as of the filing date.  Section 522 then allows a debtor to exempt (or protect from creditors) certain property from his or her estate depending on his residence.  Congress conferred upon the states very limited authority to legislate in the bankruptcy area. Section 522(b)(1) gives narrow authority to the states to either accept or reject the use of the federal bankruptcy exemptions found in section 522(d) by either opting in or out of the federal exemptions.  California is one of the states that has opted out of the federal exemption scheme.  See California Code of Civil Procedure (“CCP”) §703.130.  As such, except in cases in which a debtor has not resided in California for the 730-day period prior to the bankruptcy filing, California bankruptcy debtors must rely on the exemptions set forth in either CCP §§ 703.140 or 704.010 et seq.  Therefore, except as expanded by the Bankruptcy Abuse Prevention Consumer Protection Act of 2005 (“BAPCPA”), discussed below, debtors in bankruptcy generally receive the same protection from creditors available to California debtors who do not file bankruptcy.

Individual Retirement Accounts (IRAs)

IRAs are exempt for California debtors under either CCP §§ 703.140(b)(10)(E) or 704.115(a)(3).  CCP §703.140(b)(10)(E) allows a debtor to exempt “[a] payment under a stock bonus, pension, profit sharing, annuity, or similar plan or contract on account of illness, disability, death, age or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor”.  Courts have wide discretion in determining what is “reasonably necessary” but generally rely on what is referred to as the Moffat factors:  (1) the debtor’s present and anticipated living expenses and income; (2) the age and health of the debtor; (3) the debtor’s ability to work and make a living, including his/her training, skills and education; (4) the debtor’s ability to save for retirement; and (6) any special needs of the debtor and his/her dependents. In re Moffat, 119 B.R. 201 (9th Cir BAP 1990).  CCP §704.115(a)(3) has a similar “reasonably necessary” requirement.

In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (“BACPA”) and among the revisions to Title 11 (better known as the Bankruptcy Code) is a provision expanding the protection of retirement funds even if the debtor’s state has opted out of the federal exemption scheme.  Section 522(b)(3) allows debtors to exempt “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under §§ 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.”  For purposes of this article, those IRS Code sections include traditional, Roth and SEP IRAs.  26 U.S.C. §408(e)(1) recognizes that “any individual retirement account is exempt from taxation under this section …”  As such, California debtors in bankruptcy are no longer limited to the CCP exemptions but may independently claim the section 522(b)(3) exemption.  Congress intended to preempt conflicting state exemption laws and to expand the protection for tax-favored retirement plans that may not have been protected under state law.  A debtor’s right to exempt retirement funds under section 522(b)(3)(C) now prevails over any conflicting state exemption laws.

Section 522(b)(4) then lists the following two ways retirement funds are exempt for purposes of Section 522(b)(3)(C):

First:  “if the retirement funds are in a retirement fund that has received a favorable determination under section 7805 of the Internal Revenue Code of 1986, and that determination is in effect as of the date of the filing of the petition in a case under this title, those funds shall be presumed to be exempt from the estate.”

Second:   “if the retirement funds are in a retirement fund that has not received a favorable determination under such section 7805, those funds are exempt from the estate if the debtor demonstrates that (i) no prior determination to the contrary has been made by a court or the Internal Revenue Service, and (ii) (I) the retirement fund is in substantial compliance with the applicable requirements of the Internal Revenue Code of 1986; or (II) the retirement fund fails to be in substantial compliance with the applicable requirements of the Internal Revenue Code of 1986 and the debtor is not materially responsible for that failure.”

Section 522(b) imposes a cap of $1,171,650 on the aggregate value of assets that an individual debtor may claim as exempt under section 522(b)(3)(C) in IRAs established under either Sections 408 or 408A of the Internal Revenue Code.  Certain exceptions apply including a simplified employee pension account (408(k)) or a simple retirement account (408(p)).  Further the dollar limitations do not apply to amounts in the IRA that are attributable to rollover contributions, for example, from a previous 401K plan, and any earnings thereon.  The dollar amount increases every three years to adjust for inflation.  The next adjustment occurs April 1, 2013.

Section 522 also covers direct transfers and rollover distributions.  Subsection (b)(4)(C) states that a direct transfer of retirement funds between tax exempt accounts does not affect the exemption status.  Similarly, subsection (b)(4)(D) provides that a properly rolled-over distribution does not affect the exemption of the distribution.   As such, retirement funds like IRAs that are properly transferred via direct transfer or a tax-free rollover distribution can still be exempted.  Debtors should review their IRA accounts, including all distributions and rollovers, to be sure they are in proper compliance and exempt from taxation under the applicable sections of the IRC.  See In re Patrick,411 B.R. 659 (Bankr. C.D. Cal. 2008) (finding that improper rollovers were not exempt from the bankruptcy estate).

An issue that has been working its way through the courts has been whether a debtor can exempt an inherited IRA.  The Ninth Circuit Bankruptcy Appellate Panel recently ruled in favor of the debtor in In re Hamlin, 465 B.R. 863 (9th Cir. BAP 2012). In that case, the Chapter 7 trustee objected to the debtor’s exemption on the grounds that an inherited IRA was not funded by the debtor and therefore not exempt. Debtor’s mother had funded an IRA of approximately $32,000 and shortly after her death, debtor transferred the funds via a trustee-to-trustee transfer.  The debtor argued that Congress intended to expand the protections of IRAs including trustee-to-trustee accounts (See In re Tabor, 433 B.R. 469 (Bankr. M.D.Pa 2010) while the trustee argued that Congress only intended IRA protection for those who earned the funds (See In re Chilton, 426 B.R. 612 (Bankr. E.D.Tex 2011).  In adopting the debtor’s argument, the Hamlin court noted that Section 522 does not specify that it must be the “debtor’s” retirement funds and that the funds were originally contributed by the account holder as retirement funds and retained that status when transferred per a trustee-to-trustee transfer.   IRC Section 408(e) provides that “any” IRA is exempt from taxation and so the Hansen court interpreted that to not only include traditional IRAs but also inherited IRAs as they are expressly referenced in IRC Section 408(e)(3)(C)(ii).  Beneficiaries of inherited IRAs cannot treat the inherited IRA as their own – they cannot make contributions or rollover any amounts into or out of the account.  Note that a different result would occur if the debtor withdrew the funds pre-petition and then attempted to claim those funds as exempt.

401Ks

Many debtors have some interest in a 401K when they file for bankruptcy relief.  Section 541(c)(2) excludes from property of the estate any property that is held in trust and subject to restriction on transfer under applicable nonbankruptcy law.  401Ks are ERISA qualified plans that contain “applicable nonbankruptcy law” restrictions on alienation and are excluded from the bankruptcy estate. Paterson v. Shumate, 504 U.S. 753 (1992).  As such, 401Ks are fully exempt from a bankruptcy trustee’s or creditor’s reach.

529 Plans

Section 529 plans are popular educational savings plans for those with children going to college.   They can either be a pre-paid tuition plan or a college savings plan.   They have tax advantages as the earnings are not subject to federal tax and in most cases, state tax, so long as the withdrawals are used for applicable college expenses like tuition and room and board.

When a debtor files for bankruptcy relief, section 541(b)(6) excludes from property of the bankruptcy estate “funds used to purchase a tuition credit or certificate or contributed to an account in accordance with section 529(b)(1)(A) of the Internal Revenue Code of 1986 under a qualified State tuition program (as defined in IRC Section 529(b)(1) of such Code) not later than 365 days before the date of the filing of the petition”.  See In re Bourguignon, 416 B.R.745 (Bkrtcy.D.Idaho 2009) (holding that the relevant time period is more than 365 days for the funds to be considered not property of the estate)  Further, the funds are only exempt if the designated beneficiary was a child, stepchild, grandchild, or stepgrandchild of the debtor for the taxable year when the funds were deposited into the account and the aggregate amounts paid to programs for the same beneficiary do not exceed the contribution limits as set forth in IRC section 529(b)(6) with respect to the beneficiary.   Finally, funds placed in the accounts between 365 and 720 days before the bankruptcy filing are limited to $5,580 for each designated beneficiary’s accounts but there is no limitation on the exclusion for funds that were contributed more than 720 days before the bankruptcy filing.  The Bourguignon court noted that third party (non-debtor) contributions to the account do not make a difference with regard to the amount that is exempt since section 541(b)(6) focuses on the timing of the contributions and not the source of the contributions.  As such, debtors should consider all contributions to the 529 account pre-petition rather than just their own contributions.

Conclusion

Based upon the protections afforded to retirement accounts under state law, as well as within the context of filing for protection under the Bankruptcy Code, the use of retirement funds by debtors to pay their creditor should, in most cases, be avoided.


David A. Arietta is a certified specialist in bankruptcy law and has an office in Walnut Creek.  He primarily represents individuals and small business debtors in Chapters 7, 11 and 13.


[1] Unless otherwise stated, all statue references are to sections of the Bankruptcy Code at 11 U.S.C. et seq.

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