Only a minority of clients seem to be aware of the need to protect accumulated tax-qualified retirement benefits1 from potential future creditors. In my practice, it's often older physicians who want to make asset protection a centerpiece of their estate planning. That's because a doctor's retirement account typically holds a large portion of his wealth, and the threat to this wealth is so clear: medical malpractice claims threaten the fruit of his life's work.2

But many clients hold substantial assets in retirement plans and could benefit from creditor protection planning. And that planning has changed significantly as a result of the U.S. Supreme Court's April 4 decision in Rousey v. Jacoway3 and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.4 The new regime is more flexible and easier to deal with — freeing planners to focus on other issues.

So, what are the steps for handling asset protection planning for clients whose retirement benefits form a major portion of their assets?

TYPE OF CREDITOR

The first question to address is: What type of creditor worries the client? State and federal law allows certain creditors to access retirement benefits to satisfy definite claims.

Those preferred creditors include: (1) spouses and children who have claims for property or support under applicable state domestic relations law,5 (2) the Internal Revenue Service asserting federal tax liens6 and (3) the retirement plans themselves, for losses they suffer due to the individual's crimes or fiduciary breaches.7 Even these preferred creditors, though, must surmount procedural hurdles associated with certain types of plans.

For example, an employer-sponsored pension plan will satisfy claims made by domestic relations claimants only if the order entered meets requirements to be a qualified domestic relations order.8 For individual retirement accounts (IRAs), any domestic relations court order that meets applicable state law standards is effective.9 Similarly, the IRS has recognized that levies to enforce federal tax liens should be imposed with special caution against funds accumulated in retirement plans.10 A Chief Counsel Advisory says that payments under such levies should normally be made only when the affected employee's benefit is payable under the employee's benefit election.11

Most contract or tort creditors do not belong to one of the privileged classes. When dealing with these creditors, the next important question is whether the retirement plan holding the benefits is and will be an ERISA-qualified plan.12 The currently prevailing judicial opinion is that plans fall within that category only if they: (1) are “employee benefit pension plans” as defined in the Employee Retirement Income Security Act of 1974 (ERISA) and (2) meet the qualification requirements of Internal Revenue Code Section 401(a). The Section 401(a) qualification question is usually pretty easy to answer. The typical pension (defined benefit or money purchase), profit-sharing (including 401(k) plans) or stock bonus plans (including employee stock ownership plans (ESOPs)) is clearly designed and operated to meet those requirements, and has documents that have IRS determination or opinion letters approving their qualification as to form. Minor deviations from the strict qualified plan requirements of form or operation are not enough to disqualify the plans for this purpose. However, significant disregard of the rules, for example self-dealing with plan assets (“a personal piggy bank”) may be a disqualifier. One sometimes-troublesome qualification requirement is that such plans must be updated when the applicable law changes, which may be difficult or impossible if the plan is not continuously employer-sponsored. Sometimes, employers discontinue their business affairs without terminating their qualified retirement plans and distributing all the benefits. In those cases, the non-distributed benefits risk being deemed not held in an ERISA-qualified plan.

EMPLOYEE PLAN

When determining whether a plan is an employee pension benefit plan, the most important facts to look for are whether the plan covers “employees” and whether its assets are held by that plan's trust. For this purpose, the term “employees” does not include self-employed individuals (for example, partners or members of a limited liability company if they're taxed as partners), or the sole owner of a corporation and his spouse.13 In Yates v. Hendon,14 the U.S. Supreme Court concluded that “Congress intended working owners to qualify as plan participants,” but that plans covering only sole shareholders and their spouses fall outside of the scope of ERISA Title I. For example, a plan covering only a group of hospital-based anesthesiologists, who are all members of the LLC that had contracted with the hospital, is not an employee pension benefit plan. However, if the plan covers one or more non-owner employees (for example, if the anesthesiology group has a clerical support staff with significant accrued plan benefits), the employee pension benefit plan status applies to all its participants, including self-employed physicians.

The second important factual determination pertaining to “employee pension benefit plan” status is whether a plan trustee holds the individual's benefits. That would not be the case for plans funded through individual annuity contracts (for example, most 403(b) plans) or individual IRAs (for example, simplified employee pensions (SEPs), salary reduction simplified employee pensions (SARSEPs) and simple retirement accounts (SIMPLE IRAs)). However, in a non-typical opinion, a bankruptcy court recently ruled that the anti-alienation clause in a 403(b) tax-sheltered annuity contract sufficiently restricts the debtor's use of funds, and therefore caused that contract to be excluded from the account holder's bankruptcy estate.15

If an ERISA-qualified plan is holding the individual's benefits, there are two important results. First, all state creditor processes are pre-empted; that is to say, they are inapplicable. Second, the benefits are excluded from the individual's bankruptcy estate.16 Stated differently, such ERISA-qualified benefits are not available to satisfy general creditor claims, whether pursued through state law procedures or through federal bankruptcy.

If the individual's benefit is not in an ERISA-qualified plan, that benefit is potentially subject not only to applicable state creditor rights processes but also to inclusion in the individual's bankruptcy estate (subject to possibly being “exempted”). Such potential exposure to creditor's claims is typical for traditional IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs, 403(b) annuities and 457(b) eligible deferred compensation plans. However, for both state law purposes and bankruptcy, there then may be applicable exemptions.

States typically have schemes allowing debtors to claim exemption for certain assets from a creditor process; retirement savings are often among the assets that can be so exempted. State exemption schemes are quite varied. However, individuals under pressure from their creditors may be able to use federal bankruptcy law, which stays all state court and individual creditor self-help actions, and substitutes the more uniform federal bankruptcy law process.

Under the Bankruptcy Code — as it exists before the effective date of amendments made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 — retirement benefits that are not excluded from an individual's bankruptcy estate (that is to say, that are not ERISA-qualified plan benefits), may be exempted in certain circumstances. The applicable exemptions depend on the individual's state of residence. The Bankruptcy Code establishes a federal exemption scheme, but allows states to opt-out of that scheme.17

Several states permit domiciliaries to choose between a federal exemption scheme set forth in the Bankruptcy Code and the state's own exemptions. Under the federal scheme, retirement benefits may be exempted to the extent that they are reasonably necessary for the support of the debtor and his or her dependents. In Rousey,18 the U.S. Supreme Court held that IRA balances are retirement benefits eligible for the limited federal exemption, despite the fact that the debtor in the case had himself established the IRA and had a right to withdraw funds at any time.

Approximately 34 states have opted out of the federal exemption scheme and established exclusive schemes. For example, my home state of Virginia prohibits the use of federal exemptions but has established two separate retirement benefit exemptions.19 The first allows a debtor to claim an exemption of a dollar amount equal to the present value of an annuity of $17,500 per year beginning at age 65 (based on a specified interest rate and mortality table).20 The second allows debtors who have not excluded any ERISA-qualified plan benefits to exempt their entire IRA benefits.21 As with many states, Virginia's exemption scheme applies to state law creditor claims, as well as to bankruptcy proceedings.

REFORM ACT

The 2005 Bankruptcy Act — effective Oct. 1722 — changes the bankruptcy law protection of retirement benefits in several important ways. New retirement plan rules apply to the federal exemption scheme, and override all opt-out state exemption schemes. Those rules uniformly provide for complete exemption of employer-sponsored qualified plan benefits and a $1 million dollar exemption for IRAs.23 To be eligible for the unlimited exemption, a debtor must establish that the plan meets certain standards of compliance with tax law qualification requirements.24 Benefits in plans that have received IRS determination letters are presumed to be exempt. Benefits in plans that have not received determination letters are exempt if the participant makes one of two quite literal demonstrations. First, the participant could demonstrate that the plan is in substantial tax law compliance, and neither the IRS nor a court has determined that the plan is not qualified. Second, the participant would meet his burden if he shows that he is not personally responsible for the plan's failure to be tax qualified.

The new act's exemption scheme makes no differentiation between tax-qualified plans that are employee pension benefit plans under ERISA and those that are not. Further, the unlimited pension plan exemption applies to the portion of IRAs funded by rollovers from employer-sponsored plans. Therefore, from a practical perspective, IRA benefits also will be completely exempt. Finally, it appears that the act provides exemption for rollover eligible plan distributions — provided that they are rolled over within 60 days of their distribution date.

From a planning perspective, after Oct. 17:

  • ERISA employee pension benefit plans continue to be excluded from debtors' bankruptcy estates and from state law creditor process.

  • Employer-sponsored plans that meet liberal tax qualification criteria, and that do not meet the exclusion requirements, will be subject to the act's unlimited exemption in bankruptcy.

  • The unlimited exemption applies to benefits rolled over from plans to IRAs.

  • Contributory IRAs are subject to a uniform $1 million dollar bankruptcy exemption.

  • NonERISA-qualified plans and IRAs continue to be subject to state law creditor process, subject to applicable state exemptions.

The net result of these changes is that individuals concerned about possible creditor claims should have greater freedom to rollover their retirement benefits from one type of tax-sheltered vehicle to another. Further, bankruptcy courts' inquiries into the nature of the retirement plans should be simplified. No longer will it be of such great concern to bankruptcy proceedings whether the benefits in question are in an ERISA-qualified plan or another kind of tax-qualified retirement vehicle. The practical consequence will be the same in either case; the benefits will be beyond the reach of the participants' creditors. On the other hand, such distinctions will remain important for purposes of state law claims. For those plans governed by ERISA, state law process will be preempted. Otherwise, the applicable state exemption scheme will retain its importance.

While there is likely to be controversy and confusion regarding many features of the 2005 Bankruptcy Act, from a retirement and estate planner's perspective, it has provided substantial simplification. Retirement benefits may now be rolled or transferred between otherwise appropriate tax qualified retirement plans with less concern about creditor claims.

Endnotes

  1. For this article, by “tax-qualified retirement benefits,” I mean an individual's accounts or accrued benefits under 401(a) qualified employer-sponsored pension, profit-sharing and stock bonus plans, 403(a) qualified annuity plans, 403(b) tax-sheltered annuities, 408(a) individual retirement accounts, 408A Roth individual retirement accounts and 457(b) eligible governmental deferred compensation plans. This article does not deal with non-qualified deferred compensation plans, severance pay arrangements or similar rights.
  2. In many cases, those physicians' practices (whatever their organizational form) have made maximum allowed contributions to retirement plans on behalf of its employee or self-employed physicians over several decades and, if those plans have experienced good investment earnings, retirement plan benefits are often a large proportion of the physicians' wealth.
  3. Rousey v. Jacoway, 125 U.S. 1561 (2005).
  4. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8.
  5. 29 U.S.C. Section 1056(d)(3).
  6. 26 U.S.C. Section 6321.
  7. 29 U.S.C. Section 1056(d)(4).
  8. 26 U.S.C. Section 1056(d)(3).
  9. 26 U.S.C. Section 408 (d)(6).
  10. Internal Revenue Manual 5.11.6.2.
  11. Chief Counsel Advisory 200032004.
  12. Patterson v. Schumate, 504 U.S. 753 (1992).
  13. 29 C.F.R. 2510.3-3.
  14. Yates v. Hendon, 287 F.3d 521 (2004).
  15. 11 U.S.C. Section 541(c)(2).
  16. 11 U.S.C. Section 541(b)(1).
  17. 11 U.S.C. Section 522 (d)(10)(E).
  18. 11 U.S.C. Section 541(c)(2).
  19. Va. Code Ann. Section 34-3.1.
  20. Va. Code Ann. Section 34-34(B)-(D).
  21. Va. Code Ann. Section 34-34(H).
  22. P.L. 109-8 Section 1501.
  23. P.L. 109-8 Section 224.
  24. Ibid.