IRAs and Bankruptcy

IRAs and Bankruptcy

A common question that comes up when clients are considering chapter 7 bankruptcy is what impact bankruptcy will have on IRAs and other retirement accounts. When we file your chapter 7 bankruptcy, we have the opportunity to use what are termed “exemptions” under the U.S. and Arizona bankruptcy laws.

We will use the Schedule C to list all of the property that will be exempt from sale (or liquidation) in your chapter 7 bankruptcy. Under federal and state bankruptcy laws, there are categories and amounts of property that are exempt from the bankruptcy process. This means that you are allowed to keep the property.

The purpose of exemptions is to allow you to keep enough property and belongings to let you get a fresh start after you file bankruptcy. The amounts and type of property that are exempt are meant to ensure you can move forward in your financial life and continue to be productive and care for yourself and your family.

Some states will allow individuals to choose the state exemptions or the federal exemptions. In Arizona, when you file bankruptcy, you must use the Arizona exemptions. You do not have the option to choose the federal exemptions. This assumes that you meet the 2-year residency requirement of filing bankruptcy under Arizona law. Common examples of exemptions include personal property, your vehicle and home (up to a certain value limit), tools of the trade, and retirement accounts.

Arizona’s state law outlines the retirement account exemptions that can be used during bankruptcy in Arizona Revised Statutes 33-1126(B).

Any money or other assets payable to a participant in or beneficiary of, or any interest of any participant or beneficiary in, a retirement plan under section 401(a), 403(a), 403(b), 408, 408A or 409 or a deferred compensation plan under section 457 of the United States internal revenue code of 1986, as amended, whether the beneficiary’s interest arises by inheritance, designation, appointment or otherwise, is exempt from all claims of creditors of the beneficiary or participant.

An IRA is defined in section 408 of the U.S. Code, so it is referred to as a “408” account in the Arizona law.

Once we have filed your chapter 7 bankruptcy, a bankruptcy estate is created and your case is assigned to a trustee. The trustee is responsible for administering the bankruptcy estate. The trustee and any of your creditors have the opportunity to object to the exemptions we have claimed in your Schedule C. Although the exemptions often seem straightforward in bankruptcy cases, there are times when the trustee will object to exemptions.

As one of the most prolific bankruptcy attorneys in Tucson, I have experience handling the objections of the trustee and creditors. I have effectively argued before the bankruptcy judge to preserve my clients’ rights to keep their property.  In fact, I had the opportunity to argue a case of first impression in Arizona in 2011 that specifically had to do with the IRA exemption. In this case my client had inherited an IRA from her mother prior to filing bankruptcy. A case of first impression means that it was the first case to be litigated on the particular issue at hand. This case set a precedent for other bankruptcy cases in Arizona.

In this case, my clients, a wife and husband, filed chapter 7 bankruptcy in 2010. Back in 2005, the wife had inherited a 50% share of an IRA worth $10,723.24 from her mother. Her and her sister were beneficiaries of the IRA and within 60 days after her mother’s death, the IRA was transferred into an inherited IRA in her name and her mother’s name (as deceased). The sister agreed to take a cash payment from my client and she released her claim on the IRA. My client paid her sister from her own personal funds and kept the original balance of the inherited IRA.

Over the next 5 years, my client only took out the required distributions from the inherited IRA. By the time she and her husband needed to file bankruptcy, the IRA account had a balance of $10,032.57. When we filed their bankruptcy petition, we claimed the entire balance ($10,032.57) as exempt under the United States and Arizona bankruptcy laws.

Once we have filed for bankruptcy, both the trustee and the creditors have the right to file objections to any exemptions we claimed. The trustee objected to several exemptions. But the objection to the inherited IRA exemption ultimately made it to the bankruptcy judge. We responded to the trustee’s objection citing case laws that interpreted the exemption in our favor. Of course, the trustee also cited conflicting case law to support her argument to have the judge deny the exemption. After our initial response to the trustee’s objection, and after further review of the law, we filed an amended exemption claim as well.

We based that amended exemption on Arizona Revised Statutes 33-1126(A)(1). We claimed that the exemption was valid because it was received as a result of the death of a parent. The Arizona law states the following:

A. The following property of a debtor is exempt from execution, attachment or sale on any process issued from any court:

1. All money received by or payable to a surviving spouse or child on the life of a deceased spouse, parent or legal guardian, not exceeding twenty thousand dollars.

We had two parts of the Arizona law that supported our claim of exemption for the inherited IRA. There was no dispute that the IRA, when it was initially established by my client’s mother would have been exempt. It met all of the requirements of the exemption. And based on the Arizona and United States law, I felt very strongly that my client should be able to claim the entire amount of the inherited IRA.

The trustee objected to the fact that we were claiming the entire value of the IRA when we filed the bankruptcy petition. This amount was $10,032.57. The trustee erroneously argued that my client should only be able to claim $5361.62 as an exemption. This was the original value of my client’s half of the IRA she inherited when her mother died.

In Arizona, we are generally only allowed to use the exemptions under the Arizona law. We are one of the many states that have opted out of the federal exemptions. There is a notable exception to this. When Congress overhauled the bankruptcy code, it created a group of exemptions for retirement accounts regardless of whether or not the individual state has opted out of the federal exemptions. So in this case, we had both Arizona and federal law on our side. It was clear to me that the trustee was incorrectly interpreting the law.

In an effort to make sure my clients were able to use the full extent of the law to preserve their opportunity for a fresh start, I believed we needed to bring this issue to the United States bankruptcy judge to determine the rights of my client. In making the decision, the judge reviewed applicable laws and previous cases. As I mentioned earlier, there were not specific cases on this issue in Arizona.

However, there were several cases prior to my client’s case in Arizona that determined that exemptions should be construed in favor of the debtor. For example, “Statutes shall be liberally construed to…promote justice.” And “The exemption laws in Arizona were not created merely for the conferring a privilege on a debtor, but to shelter the family and thereby benefit the state.” (In re Herrscher)

I want to address this last quote because I think it is an important point. Many credit card companies and banks will try to create a belief in bankruptcy seekers that it is their obligation to pay back their debt, even when the terms of the credit card or loan are clearly unfair. Thus there is a belief that exemption laws are some kind of privilege, not a right that every individual has in our country.

When I became a bankruptcy attorney, I committed myself to leveling the playing field between the big credit card companies and individuals. I wanted to work on behalf of individuals who have a legal right to a fresh start that has been a part of our country’s laws since 1841. The state has an interest in helping individuals create this fresh financial start. If credit card companies and other creditors were allowed to take money set aside for retirement, this not only leaves individual families vulnerable, but also puts an additional burden on the state.

The U.S. bankruptcy judge in this case reviewed Arizona law, U.S. law, and applicable cases interpreting how IRAs are treated within and outside of the bankruptcy process. The judge also looked at several factors in making the decision in this case.

At the hearing, I presented an argument to the court that the IRA in question transferred directly from the trustee of the mother’s IRA account to the trustee of my client’s IRA account. The IRA was still in the mother’s name (as deceased) as well as my client’s name. My client took only the minimum required distributions and did not add any money to the IRA.

The trustee in this case argued that the inherited IRA was analogous to a cash inheritance. As such, the inherited IRA, argued the trustee, is not an exempt retirement plan under state of federal statute.

The judge, in making the decision, described two camps, so to speak, of previous cases. There was no Arizona law specifically addressing inherited IRAs. Looking at a case from Idaho, the judge indicated that Arizona statute “does not limit the exemption to the person who contributed the funds,…” Arizona law allows an exemption when the person is a beneficiary (which my client was) of the retirement plan.

There is a line of cases that deny exemptions in inherited IRAs under the reasoning that inherited IRAs are fundamentally different under the Internal Revenue Code and are not for retirement purposes, but rather a liquid asset. The judge in my client’s case astutely disagreed with these courts. Inherited IRAs are still protected from taxes for a designated period of time and thus are not the equivalent of a common liquid asset.

The judge went on to consider the other objections of the trustee. The trustee argued that only money that is payable to the beneficiary is considered exempt. The trustee tried to convince the judge that my client had already been paid the money from the IRA when her mother died and that she then placed the money into another IRA. Because the trustee did not provide any evidence that my client’s IRA was not in compliance with the requirements of the Internal Revenue Code for a direct transfer of the inherited IRA, the judge was not persuaded by her argument.

Another objection raised by the trustee was that my client’s payment to her sister for her portion of the IRA was a “prohibited contribution.” The judge cites IRS publication 590, stating, “an inherited IRA cannot be treated the same as your own IRA. ‘This means that you cannot make any contribution to the IRA. It also mean you cannot roll over any amount into or out of the inherited IRA.’ ”

It is possible for a beneficiary to lose the tax-exempt status of the an IRA. However, the money given to my client’s sister was not a prohibited transaction. My client’s mother’s money remained in the account and her sister released her ½ interest in the IRA for a cash payment.

Finally, the bankruptcy judge also agreed with our contention that the inherited IRA was protected under Arizona Revised Statue 33-1126(A)(1). The trustee argued against us by stating that this was only protected if it was life insurance. The judge overruled the objection of the trustee based in part on the fact that there was not specific legislative history indicating that it was meant to only refer to life insurance. The judge chose to interpret the Arizona law liberally and allowed the alternative basis for our exemption of the inherited IRA.

Not only was this case a victory for the specific clients I was working with at the time, it was a victory for other debtors in Arizona in similar situations with inherited IRAs. To be able to ensure that my client kept creditors from taking money she received from her mother’s inherited IRA gave me great satisfaction as a bankruptcy attorney. Every time I obtain a discharge for a chapter 7 bankruptcy client, I know we have struck a blow for individuals against the often predatory practices of credit card companies and banks. Bankruptcy is one way that ordinary people, like you and I, can make the choice to not become snared by a credit card system that is stacked against the little guy.