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IRA Treatment by the Bankruptcy Courts

2013 April 8
by Asset Protection Solutions

When an individual files a petition for relief under the Bankruptcy Code, all of that individual’s property (with certain specified exclusions and exemptions) becomes property of the debtor’s bankruptcy estate, which is administered under the supervision of the bankruptcy court for the benefit of the debtor’s creditors. Where a debtor’s property includes one or more IRAs, a court must determine whether such IRAs may be exempted from property of the bankruptcy estate.

In a 2005 decision, the U.S. Supreme Court held that a debtor may exempt a qualified IRA (Individual Retirement Account) from property of the bankruptcy estate under the U.S. Bankruptcy Code, shielding the funds held in the IRA from his or her creditors to the extent reasonably necessary for the support of the debtor and any of the debtor’s dependents.  This allows debtors to protect their right to receive payments from pensions and annuities.

In order for the IRA to be “exempt,” the preparer of the debtor’s bankruptcy petition must indicate that the debtor has an IRA and that the IRA is exempt under either the federal exemption, or under the Washington State retirement account exemption.  Both exemptions apply to pensions, profit sharing and stock bonus plans, Individual Retirement Accounts (IRAs), deferred compensation plans such as your 401(k) account and other funds.  There is a cap on the amount of exempt funds held in IRAs which is $1,171,650. But the sheer size of the cap means that most people who file for bankruptcy would not have to worry about it.

But a retirement account is only protected as long as it actually is an IRA.  IRA’s may become disqualified for bankruptcy exemption protection if the debtor engages in a “prohibited transaction.”  But what exactly is a prohibited transaction?  Here’s a general list of actions that a debtor can make which can result in an IRA no longer receiving “exempt” status:

  • Certain transactions with an IRA account are prohibited if a “disqualified person” is involved in the transaction.
  • Disqualified persons include the IRA owner, certain family members, any other fiduciary and certain service providers (among others).
  • Prohibited transactions include the following:
    • a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
    • any act of a fiduciary by which plan income or assets are used for his or her own interest;
    • the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
    • the sale, exchange, or lease of property between a plan and a disqualified person;
    • lending money or extending credit between a plan and a disqualified person; and
    • furnishing goods, services, or facilities between a plan and a disqualified person.
  • If a prohibited transaction occurs, the IRA ceases to be an IRA as of the first day of the tax year in which the transaction took place.

So why is this important to you?  Creditors are becoming more aggressive when it comes to exemptions.  They will not hesitate to dig up any available information to attempt to convince a court that exemption claims should be set aside.  If a creditor is able to prove that the debtor has engaged in a prohibited transaction, and the IRA is no longer exempt, the Trustee is allowed to seize that asset, liquidate it and distribute those proceeds to your creditors, essentially robbing you of your retirement assets.

If you are considering any kind of transaction with your IRA, other than buying and selling in traditional stocks, bonds and mutual funds, you need to consider consulting with our offices, which are experienced and knowledgeable in this area.  We are here to help keep you out of trouble.

Jared Bellum is a contributing author to this blog and has been admitted to practice law in the state of Washington.  He practices in the fields of bankruptcy, real estate law, business law and estate planning.  JD Bellum, Attorney at Law, PLLC works in association with the Law Offices of Richard D. Seward, PC.

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