Laws In Transition
Federal Bankruptcy Protection For ERISA Qualified Assets
An Overview of Bankruptcy Exemptions
Other Ways To Protect Retirement Plan Assets
What About A Possible Government "Pension Grab"?

This report offers some good news relative to your tax deductible pension or profit sharing plan assets. First, if your plan meets the tests of being an ERISA qualified plan, the assets in the plan can't be taken by a trustee in bankruptcy. Second, even if your plan is not an ERISA qualified plan, it may be protected from the claims of creditors under state law. However, there are some exceptions to these general rules, and the laws are still evolving. Finally, if your retirement savings are not protected by ERISA or by state law, this report offers a few suggestions about other ways to protect those assets.

In 1992, the Supreme Court made a landmark decision (Patter- son v. Shumate) relative to the rights of creditors to tax qualified savings subject to the Employee Retirement Income Security Act (ERISA). Basically, the court held a person's qualified plan assets are protected from creditors in bankruptcy. Many commentators imply that this is the final word on the topic. 

However, Al Martin (an ERISA lawyer in the Kansas City area) tells me there have been a variety of new cases about the rights of creditors to tax qualified assets since that Supreme Court decision. These new cases raise exceptions to the Supreme Court decision. Meanwhile, state laws are in a state of flux. 

Gideon Rothschild tells me that New York has recently passed new laws that extend their state bankruptcy exemptions to include all forms of tax qualified retirement savings plans, including IRAs. These changes bring New York into line with about half the other states that have already passed similar laws. A syndicated column by Kathy Kristof (L.A. Times Syndicate) said that Congress overhauled the Federal bankruptcy laws in late October, 1994. According to Kristof, the law was effective on the date it was signed and will make it easier for the IRS to collect their taxes, but she made no comment about any changes that relate to tax qualified retirement plans.

According to Noel C. Ice, Esq., in an article in Estate Planning (January/February, 1994), "The courts have long held qualified plan assets to be exempt from execution by creditors if the debtor is not in bankruptcy. In Patterson v. Shumate, a unanimous Supreme Court held that a participant's benefits cannot be reached by creditors in a bankruptcy proceeding." 

Although it would be nice if the Supreme Court decision were really the last word on the subject, there are other issues that weren't addressed by the court and there have been a number of lower court cases that have dealt with these other issues. The interplay between the ERISA laws and the bankruptcy laws are a highly technical and often contradictory set of laws. In addition to sending my draft of this report to all of my editorial advisors, I sent a draft copy to Al Martin, an attorney in the Kansas City area who specializes in ERISA related matters. Al gave me a copy of an eight page conference outline he has been using to make presentations on this topic for legal conferences and he offered a number of very helpful suggestions on this issue. 

According to Al Martin, the Supreme Court held that plans covered by ERISA are generally not subject to the control of a bankruptcy trustee. According to the Supreme Court, "ERISA creates a 'restriction on the transfer' of a debtor's pension money since it states that benefits in a pension plan cannot be assigned or alienated. ..." However, the Supreme Court did not specify with precision what types of pension plans would constitute 'ERISA qualified' plans". 

Since the Supreme Court case, a number of lower court cases have dealt with some related issues. One issue involves whether a particular plan is "ERISA qualified". Another involves the question of whether a plan without participants other than the owner (and his/her spouse) is protected. It seems that where the plan doesn't cover any employees other than the owner and his or her spouse, the plan may not be protected. A third issue relates to the question of whether bankruptcy trustee can establish that a plan is not a qualified plan, because it has not been operated in accordance with IRS regulations. 

Where plan assets are not protected under ERISA, other cases relate to the question of exemptions under the laws of various states. Most of these issues are still in a state of flux with conflicting opinions by different courts. The exceptions to the Supreme Court decision are still evolving. But there are some generalities that can be made about the status of these issues at this time. What types of plans are protected by ERISA? 

Generally, tax qualified retirement plans will be protected from the claims of creditors of the plan participants when the plan is a (1) defined benefit plan or a (2) defined contribution plan. Defined contribution plans include profit sharing plan, employee stock ownership plans, money purchase pension plans, target benefit plans and 401(k) plans. 

Generally, the Supreme Court case does not protect non ERISA retirement plans from being taken by a bankruptcy trustee. These non ERISA protected plans include an IRA, a SEPP-IRA, a 403(b) tax deferred annuity plan and government plans. There is a dispute among the courts as to whether a plan with only owner-employee participants is a "plan with employees" and thereby protected by ERISA. According to Al Martin, three courts have said, "No.", but a fourth court has disagreed. From a practical perspective, it may be worth the cost of providing some benefits to a rank and file (non-owner) employee so that your own plan assets are protected. Otherwise, you will have to rely on the protection available under state law.
 
 

Even if a retirement plan isn't protected from bankruptcy under ERISA, it may be protected from the claims of creditors if it is protected under state bankruptcy exemptions. Some states exempt all types of tax qualified retirement savings plans - including an IRA. Each state sets its own limits on how much can be protected from creditors in a bankruptcy proceeding and they vary greatly. These exemptions may change from year to year, so it's essential to be sure you are relying on current information in your state, rather than on this list. 

The most common state exemptions include, 

            (a) ERISA plans,

(b) state/public employees, 

c) teachers and school employees, 

(d) elected officials, 

(e) law enforcement/police officers, 

(f) firefighters, 

(g) IRA deposits up to (______), 

(h) Private retirement benefits, Keoghs.

This tabulation is based on a composite of information from two references on bankruptcy law. Each book includes a full page on the exemptions in each state. Where there were differences, I relied on the second book because it's more current. (1) Asset Protection Secrets, by Arnold S. Goldstein, Garrett Publishing, 312 S. Military Trail, Deerfield Beach, FL, 33442. (305-480- 8543). (2) How To File for Bankruptcy (4th Ed.) Elias, Renauer & Leonard, Nolo Press, 950 Parker Street, Berkeley, CA 94710. (800- 992-6656) (Note that neither book showed the current status in Kansas, so the data for other states may not be current.) 

I welcome any information from readers who are familiar with the current exemption status of various states so that I can update this table.

If your retirement benefits are in a plan that is protected by ERISA, and where the plan provides coverage for employees other than yourself and your spouse, those retirement plan assets should be secure from the claims of present or future creditors. 

Where your money is in a plan not protected by ERISA, you should check to see whether it is protected by bankruptcy exemptions in your state. 

But, what if neither form of protection is available for your retirement savings? Here are some observations and suggestions about some other ways to protect your retirement savings. I would welcome information from any readers who are willing to share any research or information about other ways to protect retirement plan funds from creditors. 

1. Put IRA rollovers back into an ERISA plan

If your state does not provide a strong exemption for assets in an IRA, and if the money in your IRA came from a rollover out of an ERISA qualified plan, some advisors have suggested that you would have more protection to roll the money back into the ERISA type of plan. However, if you put the rollover account back into an ERISA type of plan, you will have to get some answer to the question of whether such plans must be plans for the benefit of employees other than the owner and the owner's spouse. Here's the real deal, as I see it. If state bankruptcy exemptions don't provide enough protection, then you have little to lose (other than the annual costs of plan administration) by doing a reverse rollover back to an ERISA plan. 

However, you need to talk to an ERISA specialist about whether your rollover IRA can be rolled back. Generally, it can, so long as the funds from the ERISA plan have been kept separate from other IRA contributions in a "conduit" IRA. If you have co-mingled funds from a rollover with new IRA contributions or have combined multiple IRAs, then you can't reverse your rollover and move the money back to an ERISA type of plan. 

2. Can you have an offshore trustee for your qualified plan?

Most folks are convinced there is no way that any qualified plan assets can be moved offshore, let alone to have a trustee in a foreign jurisdiction. Gideon Rothschild informed me that it's possible to have a qualified plan trust with an "ancillary trustee" that is not in the U.S. If there is a danger of a creditor attack, the U.S. trustee transfers the assets to the ancillary trustee. Apparently that distribution is not a taxable event but any income earned by the trust is then taxable. 

At this point, I need to get more information about this concept before I can explain it accurately and before I can provide enough citations to give comfort to your local advisors. I'm going to continue to explore this novel concept and will report on what I learn in future issues of APS. 

3. Pay the taxes and move the money into a protected entity

One somewhat obvious choice is to withdraw the funds from your retirement account, pay the taxes and then move the money into some other form of asset protection - like a family limited partnership or an offshore trust. I would suggest that this should be treated as a last resort. By taking the money out, you will be giving the IRS up to half of your retirement savings and there will be substantial risk that the rest can still be taken by your creditors. As a practical matter, if you are at a point where creditors are almost pounding on your door, any transfer to a FLP or offshore trust is likely to be deemed a fraudulent conveyance by the courts. Even the assets in an offshore trust could be attached where the applicable statute of limitations hasn't run. 

Are there any ways you can mitigate the tax burden? I'm not aware of any safe or easy ways to avoid taxes on the money you take out of a tax qualified plan. 

The safest idea I can think of is to put that money into a charitable trust in exchange for a lifetime income. Depending on your age, part of your contribution to the charitable trust will be deductible and will offset the income you generate from taking money out of your qualified plan. 

Here are some more aggressive possibilities you might consider if you need to get your money out of your qualified plan and you are not "under the gun" with creditors.

* If you live in a state with a strong homestead exemption, you might take the money out of your IRA and use it to pay off a home mortgage. That will result in some income taxes, but this is a strategy that could work even if you are concerned about an imminent judgment.* If you own a business, convert your plan into an ESOP and use tax deductible plan contributions to build up a fund to buy you out when you retire. * Invest in an oil and gas drilling program so that the deduction offsets the income from your IRA. If you have a working interest, you will not be subject to the passive activity loss limitations.

Prior to the Republican victory in the 1994 elections, a number of writers were have urging their readers to cash out their pension and IRA funds because of their concern that the government was getting ready to tap into the huge 4+ trillion of tax deferred pension and retirement savings funds. 

My comments on the possibility of mandated investments by pension plans is discussed in my report on that topic. 

Further details about protecting your pension assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.

I'd like to offer special appreciation to Alson R. Martin for his help with this report. Al is an attorney with Shook, Hardy & Bacon P.C., P.O. Box 25128, Overland Park, Kansas, 66225. (913-451-6060).
 
 

Further details about protecting your assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.

NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified  professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.

About the author:

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant.  He  sponsors and moderates a free discussion group on asset protection and offshore topics.  His email address is vkj@rpifs.com.  He can be reached by phone or fax at (913) 362-9667.

Your suggestions for improving this web site are most welcome.