Confusion with the New Bankruptcy Act:
IRAs, Rollover IRAs, and Homestead

Exemption for IRAs

Many financial planners – and even some alleged asset protection planners – have been giving advice that IRAs are now inherently asset protected. Their advice is based on last year’s bankruptcy act, which we covered extensively in our May 2005 Developments. But are IRAs really protected from creditors?

The new bankruptcy act added a new paragraph (n) to section 522, which deals with exemptions. This new paragraph (n) provides in relevant part that “[f]or assets in individual retirement accounts . . . the aggregate value of such assets exempted under this section . . . shall not exceed $1,000,000 in a case filed by a debtor who is an individual . . ..” Thus, it is clear that in bankruptcy an IRA is protected up to $1,000,000.

The problem is the two operative words “in bankruptcy”. Paragraph 522(n) solely, only, and exclusively provides protections to IRAs in a federal bankruptcy proceeding. However, this provision has absolutely no application at all to proceedings outside of bankruptcy. It does not, for example, override state law relating to IRAs in either state court proceedings or in non-bankruptcy federal proceedings. In other words, for the protections of Paragraph 522(n) to apply at all, the debtor who seeks to protect his IRA must actually be in a bankruptcy proceeding.

Many states give very little protection to IRAs. This means that if a debtor has a lot of money in their IRA, they will have to file for bankruptcy to protect it. However, there may be reasons that the debtor may not want to file for bankruptcy.

One reason is that by filing for bankruptcy, other favorable state exemptions could be superseded by the bankruptcy act. For example, somebody living in a state with favorable homestead protection who has not yet met the 40 month requirement might face a difficult choice as to whether to file for bankruptcy and protect their IRA but lose their home, or to not file for bankruptcy and protect their home but lose their IRA.

Another example of somebody who probably will not want to take bankruptcy is a wage earner, since under the new changes to the bankruptcy laws they may be required to work off their debts over a long period of time in order to obtain a discharge.

The upshot is that even though an IRA is protected in bankruptcy, one should not rely on that protection unless they live in a state that substantially protects IRAs. Are IRAs inherently asset protected? Yes and no, but mostly no.

Rollover IRAs

Many advisors are now stating that although IRAs are subject to a $1 million limitation, there is no limitation for “Rollover IRAs”. This position is taken section 522(n) refers to “the aggregate value of such assets exempted under this section, without regard to amounts attributable to rollover contributions . . . and earnings thereon” (emphasis added). The claim, which is not yet supported by any case law, is that this language creates an unlimited exemption for Rollover IRAs. In other words, the exemption for a normal IRA may be limited to $1 million, but a Rollover IRA could theoretically be $5 million and still exempt.

Some advisors believe in this position so strongly that they are actively telling their clients to liquidate other assets and put them into an IRA, and then roll the IRA into another IRA so that as a Rollover IRA it gains this unlimited exemption.

But is the exemption for a Rollover IRA really unlimited? I do not believe that it is. First, there is scant evidence that Congress specifically intended to create such a huge exemption. Second, the mere fact that such a large exemption is created runs contrary to the very anti-debtor/pro-creditor tenor of the act. Third, there is simply no intelligent reason whatsoever why Rollover IRAs should have such a large exemption, but non-Rollover IRAs do not.

What you have here is a typical case of sloppy drafting. What I am pretty sure that Congress meant to say (and believe that a court will rule) is that the exemption for IRAs is $1 million, and it doesn’t matter how much of that $1 million came from Rollover IRAs. In other words, the total exemption is $1 million for IRAs and Rollover IRAs in the aggregate, and there is no special exemption for Rollover IRAs. While it is possible that a court could interpret the language to create such an exemption, I doubt that will happen because of the overall anti-debtor/pro-creditor tenor of the act.

So, mark me down as one who does not believe that Rollover IRAs have an unlimited exemption in bankruptcy. But even if an advisor believed that this is the case, they should not be advising clients to contribute money to Rollover IRAs until the issue is settled by the courts. If an advisor tells a client with more $1 million in a Rollover IRA that the money is exempted, and the courts ultimately rule the other way, the advisor could very well be liable for malpractice (especially if the advisor is a non-attorney advisor who shouldn’t even be giving such advice in the first place). In the absence of case law validating the exemption, advisors who affirmatively tell their client that there is an unlimited exemption for Rollover IRAs are basically playing Russian Roulette with their clients’ accounts.

Further, even if the courts ultimately rule that Rollover IRAs are exempted, keep in mind that as with normal IRAs this exemption only applies in bankruptcy proceedings, and not in ordinary state or federal cases. So, whether or not a greater than $1 million exemption exists, it is probably bad advice to tell clients to load up their IRAs for asset protection, since that will later force them to take bankruptcy to try to protect the IRA.

One should keep in mind that the very purpose of bankruptcy is to marshal the debtor’s assets to satisfy creditors, and not to protect the debtor’s wealth. The presumption is always that an asset of the debtor is an asset that is available to creditors, in the absence of clear state or congressional intent that the asset should be exempt. Especially with the latest changes to the bankruptcy laws, debtors should normally avoid bankruptcy whenever possible, and certainly not anticipate taking bankruptcy as part of their asset protection plan. Yet, by telling their clients to load up their IRAs, that is implicitly what many advisors are doing.

Homestead Confusion

If one wants to see that there is great confusion in how the provisions of the new bankruptcy act are being interpreted, they need only to look at how the changes to homestead exemption are being interpreted. The new act basically created a 40-month grandfather period for homestead exemption: If the property had been owned for less than 40 months, then the $125,000 cap on homestead of section 522(p) applies regardless of contrary state law. But if the property has been owned for more than 40 months, then the state homestead law applies.

While that part is clear enough, questions then arise as to increases in equity within the 40-month period. For example, let’s say that you live in a state with unlimited homestead, you initially put $250,000 into your home, and now you have owned the home for over 40 months. There is no doubt that your $250,000 initial equity is protected. But what about your house payments, and the increase in value to the house within the last 40 months: Is that protected too?

Let’s further assume that within the 40 months before you filed for bankruptcy, you made $100,000 in principal payments on your loan. Can you claim that since your home was bought more than 40 months before you filed for bankruptcy, the additional $100,000 in principal payments that you made should be protected to?

Currently, it depends on where you filed for bankruptcy, since the courts are split on whether principal payments within the 40-month period are exempted, with most courts holding that the $125,000 cap does apply. In re Virissimo and In re Heisel, Chapter 7, Case Nos. BK-S-13605-LBR and BK-S-05-15667-LBR (Bankr. D. Nev. 2005) ($125,000 cap on exemption applies); In re McNabb, 326 B.R. 785 (Bankr. D. Ariz. 2005) ($125,000 cap on exemption applies); In re Kaplan, Chapter 7, Case No. 05-14491-BKC-RAM 331 BR 483 (Bankr. S.D. Fla. 2005) ($125,000 cap on exemption applies). But see In re Wayrynen, Chapter 7, Case No. 05-32144-BKC-SHF (Bankr. S.D. Fla. 2005) ($125,000 cap on exemption does not apply). In other words, there is no solid answer. The bottom line is that you shouldn’t count on principal payments or appreciation in value within the 40-month limitation being protected in bankruptcy.

There are ways to protect the owner’s value in personal residences. These methods include contributions to certain types of trusts that have asset protection features, and debt-financed methods of stripping equity from property. Where property has significant equity, these methods should be employed now to get the applicable Statutes of Limitation running, and if the owner gets into financial trouble later, bankruptcy should be avoided if at all possible.

As with IRAs discussed above, what this illustrates is that nobody knows how many of the issues created by the new bankruptcy act will shake out. It will likely be some years before there will be opinions decided by the U.S. Court of Appeals such as can reasonably be relied upon by planners and litigants. In the meantime, planners should presume the worst and not rely on wishful pro-debtor interpretations of the act.