Protecting a Retirement Account in Bankruptcy
Under the United States Bankruptcy Code, retirement funds, to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the IRS Code, are exempt from the Bankruptcy Process. While Virginia has opted out of the Federal exemption process, Virginia law section 34-34 provides that the interest of an individual in these accounts are exempt to the extent that they are exempt under Federal bankruptcy law, whether said interest is as a participant, beneficiary, or otherwise. Ordinarily, your retirement accounts will be protected from the Bankruptcy Process in Virginia through the operation of this code, rendering them completely exempt. However, there are at least three circumstances in which you may end up losing these benefits to your creditors – the case of a non-exempt account, the case of an alternate payee, and the case of an inherited account.
Under Federal bankruptcy law, a retirement account is usually only exempt to the extent that it is exempt from taxation. Many financial instruments that one might think of as retirement accounts – mutual funds or certificates of deposit – are not exempt. In addition, if a retirement account is not in compliance with the Tax Code, it may lose its benefits from the IRS, which means it may lose protection in bankruptcy. This can occur when the plan is improperly funding, or when the plan does not comply with other formal requirements of the IRS code. Finally, while most debtors will never need to consider this limit, IRAs under § 408 and Roth IRAs under § 408A have a specific value limit of $1,245,475.00 that may be held exempt in all such accounts – anything over may be seized by the Trustee. This is a per-debtor limit, not a per-account limit, so division into multiple accounts will not work.
The Virginia code, on the other hand, specifically does not apply alternate payees – spouses, former spouses, children, or other dependents of a participant who have been given the right to receive some or all of the benefits of the account under a qualified domestic relations order – from the exemption on creditor process. In addition, it does not apply to those who would be alternate payees but who are on non-ERISA retirement accounts, as well as against the Commonwealth when enforcing a child or child and spousal support obligation.
Finally, in a decision which may potentially be considered advisory in the Fourth Circuit, the Seventh Circuit held on April 23, in the case of In re Clark, that a non-spousal inherited individual retirement account (inherited IRA) is not considered to be an individual retirement account (IRA) for the purposes of the Bankruptcy Code’s exemption statutes. These statutes, protect “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986,” and cover most individual retirement accounts in place today. While inherited IRAs remain tax-exempt, the the Seventh Circuit’s interpretation of the law states that nevertheless they lose their status as retirement accounts upon their passing to the new beneficiary. According to their reasoning, while the tax-exempt status remains intact, all other characteristics change upon the former account-holder’s passing – most importantly, the funds must begin distributing its assets within 1 year, and complete distribution within 5. In short, these funds may no longer be saved as retirement funds, and should no longer be treated as such. While Virginia has not followed this line of reasoning yet, until it chooses to do so, such an inherited IRA may be considered at risk.