Courts rock waters on bankrupt 401 (k)
What would you like to know
- Inherited 401 (k) may benefit from creditor protection in bankruptcy if the funds remain in the inherited account when the bankruptcy petition is filed.
- But the Supreme Court unanimously ruled that inherited IRAs were not “retirement funds” and therefore were not eligible for bankruptcy protection.
- An appeals court found that debtors cannot protect their assets from bankruptcy by starting contributions after filing for bankruptcy.
Typically, creditors are unable to access a client’s 401 (k) or traditional IRA in bankruptcy. As most clients know, however, different rules apply to different types of retirement accounts – and a whole new set of rules apply to legacy retirement accounts.
Years ago, the Supreme Court ruled that inherited IRAs did not have the same bankruptcy protection as traditional IRAs because inherited accounts were not accumulated for the debtor’s retirement savings. But recent court cases have muddied the waters somewhat when it comes to determining the level of creditor protection that a legacy retirement account might receive in bankruptcy – and it’s critical that clients with creditor protection issues understand the nuanced differences that can apply in the future.
Creditor protection and 401 (k) inheritance
The U.S. West District of North Carolina Bankruptcy Court recently ruled that inherited 401 (k) may also be eligible for creditor protection in bankruptcy if the funds remain in the inherited account when the claim is made. bankruptcy is filed.
A key factor in the case was that the funds remained in the legacy 401 (k), which was set up by the financial institution on behalf of the debtor (in other words, the results would have been different if the beneficiary had withdrawn the funds from the account by taking a distribution or rolling the funds into an IRA).
The court concluded that the purpose of the Employees Retirement Income Security Act was to protect both pension plan members and their beneficiaries, so it was important that the funds remain in the account protected by the ‘ERISA.
The court specifically distinguished this treatment for plans covered by ERISA from the treatment of legacy IRAs, which may not be protected in bankruptcy. In Clark v. Rameker, the Supreme Court unanimously ruled that inherited IRAs were not “retirement funds” and therefore were not entitled to bankruptcy protection.
This particular case, however, was decided by a lower district court and is apparently a case of first impression. The case also involved a plan covered by ERISA, meaning that customers who contribute to non-ERISA plans may not benefit from the same protections. Therefore, clients should proceed with caution and examine state laws to determine whether inherited 401 (k) can be excluded from a bankruptcy estate.