On April 20, 2005,
President Bush signed into law the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 (BAPA). The new law generally makes it
tougher for people to protect their assets, but there are some
exceptions. For instance, IRAs, fast becoming the biggest asset people
have, actually receive more protection under the new law, which takes
effect on October 17, 2005
Under the new law, up
to $1 million of assets held in a traditional IRA and Roth IRA, or a
larger amount determined by the bankruptcy court “in the interests of
justice,” will be exempt from the IRA owner's bankruptcy estate.
What’s more, IRA assets
that came from an employer retirement plan rollover (such as a 401(k),
403(b), or profit-sharing plan) will not be subject to the claims of the
IRA owner’s creditors, regardless of the state in which the IRA owner
resides or the value of rollover assets and their subsequent growth.
BAPA has other details
to digest as well. For instance, the new law also reinforces the
unlimited protection for 401(k) plans, 457 plans, 403(b) plans,
governmental plans, and tax-exempt organization retirement plans, and
adds to the list exemptions from the bankruptcy estate for SEP-IRAs,
SIMPLE IRAs, Keogh plans and solo 401(k) plans. And given unlimited
bankruptcy creditor protection, such retirement accounts are likely to
become even more attractive retirement-savings vehicles in years to
come.
Also, retirement funds
in transit from one IRA or retirement account to another are also
protected under the new bankruptcy law. The law even provides protection
if funds are withdrawn from an IRA and rolled over within 60 days back
into an IRA or retirement account.
But not all facets of
IRAs are protected. For instance, required minimum distributions, 72(t)
distributions, and hardship distributions are not protected under BAPA.
Once money is withdrawn from a plan it is no longer protected.
What’s more, the new
law provides greater creditor protection for IRA assets, but only in
bankruptcy. They do not apply to judgments awarded in other courts where
state creditor protection laws will apply. And BAPA will not stop a
divorcing spouse from taking a share of the pension.
So what’s the
significance of the new law? First, the new law creates clarity where
there had been confusion. Prior to BAPA, it was difficult to determine
how a person’s IRA would be exempt from claims of his or her creditors
if they filed for personal bankruptcy. There was such a confusing mix of
federal and state laws and court cases that a person did not know
whether or how much of his/her “rollover” IRA would be subject to claims
of creditors. That is no longer the case. Of note: IRA owners who live
in states that have poor IRA creditor protection benefit most from the
new law.
One implication of the
new law: Investors may want to keep IRAs that are funded with rollover
contributions separate from IRAs funded with annual contributions. The
Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 made
obsolete the need to create a conduit IRA, but the new law provides an
incentive to have separate IRAs – an IRA funded with rollovers and one
funded with contributions. To commingle rollover and contributory IRA
assets would make it difficult to identify which portion of the IRA
represented assets that are “unlimited protection” rollovers (plus
earnings) and which portion represented IRA contributions and earnings
(subject to the $1 million limitation).
The new law also
encourages investors to rollover their 401(k) to an IRA after they leave
an employer. Prior to BAPA, investors often left their funds in their
former employer’s 401(k) plan since such plans were fully protected from
bankruptcy. But now 401(k) plans and IRAs have near equal protection
from creditor claims, so there’s less reason to leave such funds behind.
Of note, there are some
good reasons to transfer funds from a 401(k) to an IRA. For instance,
transferring a 401(k) to an IRA not only broadens investment options,
but also may open the door to create what some refer to as a “stretch
IRA”, an IRA that continues to grow tax-deferred over the life of its
beneficiaries. The downside to leaving money in a 401(k) plan is that
oftentimes money in such plans must be immediately distributed to
beneficiaries after the plan participant dies, eliminating any chance of
the plan participant creating a stretch IRA.
But there are some good
reasons to leave the money in a 401(k). For instance, qualified
retirement plans are protected under ERISA, which extends to judgments
other than bankruptcy, regardless of your state law.
Like all new laws, BAPA
will likely be challenged at some point by creditors in the courts. So
it would be considered prudent to seek the advice of your financial
planner and a bankruptcy attorney, and frequently review any legal
challenges and clarifications issued by federal authorities including
the Internal Revenue Service (IRS) or Department of Treasury.
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July 2005 — This column is produced by the Financial Planning Association, the
membership organization for the financial planning community.
