Most people in the retirement plan industry know that, in general, funds in qualified Employee Retirement Income Security Act (ERISA) plans are protected from creditors.

However, recent court decisions have expanded on the protections provided in some more specific circumstances. The treatment of retirement savings in bankruptcy does come up occasionally, but people often don’t realize how different situations can lead to different outcomes, says Allison Itami, principal at Groom Law Group, Chartered, in Washington, D.C.

Christopher S. Lockman, partner in the employee benefits and executive compensation group at Verrill, in Portland, Maine, who was a bankruptcy lawyer before turning to employee benefits law, says when a person files for bankruptcy, in a lot of ways it is like what happens when the person dies—the debtor’s interest in their assets freezes, and a bankruptcy estate is created.

However, he adds, the U.S. Bankruptcy Code allows for exemptions. Regardless of whether a debtor uses the federal exemption under Section 522(b)(2) of the Bankruptcy Code, or the state exemption under Section 522(b)(3) of the Bankruptcy Code, both list accounts exempt from taxation under Internal Revenue Code (IRC) Sections 401, 403, 408, 408A, 414, 457 or 501(a) as exempt from a debtor’s bankruptcy estate. “In general, retirement account assets are exempt from seizure,” Lockman says.

He says the logic is that a person is incapable of getting a fresh start if you strip away his retirement savings. “Part of getting a fresh start is that when you hit retirement age, you don’t end up as a ward of the state,” he says.

Itami notes that recommendations concerning rollovers of retirement plan assets have been a hot topic in the advisory industry. For reference, the Financial Industry Regulatory Authority (FINRA)’s Regulatory Notice 13-45 reminds advisers of factors to consider when making a recommendation to roll over retirement plan assets to an individual retirement account (IRA). The notice says, “Generally speaking, plan assets have unlimited protection from creditors under federal law, while IRA assets are protected in bankruptcy proceedings only. State laws vary in the protection of IRA assets in lawsuits.” Itami says this is the basis of the idea that retirement savings are safer in an ERISA plan.

Lockman says, besides using exemptions, a second way someone can exempt retirement assets from a bankruptcy estate is to say those assets are not part of the bankruptcy estate in the first instance. He says that’s the argument used in a bankruptcy case ruled on last year.

Protection for Inherited Retirement Accounts

In the recent case, In re: Dockins, the U.S. Bankruptcy Court for the Western District of North Carolina considered whether a 401(k) account inherited by a debtor prior to her filing Chapter 7 bankruptcy is protected from creditors. The court concluded that the fund is not the property of the bankruptcy estate, and the debtor does not need an exemption to keep it.

In the case, the trustees argued that the inherited 401(k) has the same legal characteristics as an inherited IRA, and, in Clark v. Remeker, the U.S. Supreme Court found an inherited IRA could not be exempt from the bankruptcy estate of the petitioner. The Supreme Court decision turned on whether the funds in the IRA could be considered retirement funds, “set aside for the day an individual stopped working.” In determining that the inherited IRA did not qualify as “retirement funds,” the Supreme Court looked at three legal characteristics of the inherited IRA: 1) the holder of the funds can never invest additional funds; 2) the holder must withdraw the funds within a certain amount of time; and 3) the holder can withdraw the full balance of the account at any time without penalty.

In sum, IRAs are protected in bankruptcy, but inherited IRAs are not, Lockman explains.

The trustee for the Dockins bankruptcy estate argued that all three characteristics applied to the female debtor’s inherited 401(k) account. The judge rejected that argument, saying “the legal characteristics of inherited IRAs relevant to the Supreme Court’s analysis in Clark are not relevant to the analysis of 401(k)s.”

According to the court opinion, Bankruptcy Code Section 541(c)(2) says “A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” The judge noted that the Supreme Court found that ERISA’s anti-alienation provision—Section 206(d), which says benefits under a plan cannot generally be assigned or alienated—is enforceable under bankruptcy code.

The judge also cited prior case law finding that as long as assets remained in an ERISA plan, they were not part of the bankruptcy estate. “Therefore, the 401(k) funds are not property of the estate under Section 541(c)(2),” the judge ruled.

Itami notes that the court said the fact that the petitioner could have taken a distribution didn’t take away ERISA protections.

Lockman says the Dockins decision is well-reasoned. “The judge saw past some bad facts to a result that balances the principles of ERISA with the objectives of the Bankruptcy Code,” he says.

“The debtor’s counsel was smart and showed courage by committing to the narrative that the beneficiary/debtor’s interest was not part of her estate because it was protected by the anti-alienation provisions under ERISA, rather than arguing it was ‘exempt’ as a retirement asset,” he explains. “Retirement plan assets have absolute protection from alienation, except in the case of a QDRO [qualified domestic relation order] and rare instances where there is misconduct regarding the plan.”

Lockman notes that until the Supreme Court ruled that inherited IRAs are not protected in bankruptcy, there was a circuit split. So, regarding other issues about the scope of retirement assets protected in bankruptcy, to the extent that different facts allow for different arguments, there could similarly be different court opinions.

Protection for Contributions to DC Plans

In another recent case, Penfound v. Ruskin, the 6th U.S. Circuit Court of Appeals explains that the principal benefit of Chapter 13 of the Bankruptcy Code is that debtors may “obtain some relief from their debts while retaining their property.” To take advantage of the protection, a debtor must commit all of his “projected disposable income” to his creditors for a fixed period of time under a repayment plan.

While the code doesn’t explicitly define “projected disposable income,”—though it does give a definition of “disposable income”—several courts have weighed in on what is included in “projected disposable income.” The 6th Circuit noted that in Davis v. Helbling, it found that the Bankruptcy Code’s definition of “disposable income” is backward-looking—that definition is determined based on the debtor’s “current monthly income,” which is defined as his average income over the six full months preceding bankruptcy. From this, the appellate court determined that a debtor is allowed to deduct from disposable income the average amount he contributed to his 401(k) each month in the six months preceding his bankruptcy.

The male debtor in Penfound v. Ruskin had previously made regular contributions to a 401(k) plan, but in the months leading up to the bankruptcy filing, he had worked for an employer that did not offer a 401(k). However, the month before filing for bankruptcy, he began working for a new employer, and he wanted to contribute $1,375.01 to the new employer’s plan and have that amount excluded from his disposable income for the purposes of the bankruptcy plan. The 6th Circuit ruled that it did not matter that he did not have the opportunity to participate in a plan in the months leading up to his bankruptcy, and that because he wasn’t contributing regularly in the six months previous to the bankruptcy filing, he could not exclude the $1,375.01 from his projected disposable income.

Lockman says the 6th Circuit’s decision in Penfound is well-reasoned and was clearly intended to prevent abusive pre-petition bankruptcy planning.

Lockman explains that Chapter 13 bankruptcy is similar to Chapter 11 bankruptcy for businesses: Instead of expunging all debts in a liquidation, as in a Chapter 7 bankruptcy, the debtor has to come up with a repayment plan dedicating all disposable income to repay creditors, which has to ultimately be approved by the bankruptcy court. He says it was a close question for the court whether contributions to a retirement plan are considered disposable income or not, but the 6th Circuit found that, in certain cases, contributions can be protected from creditors. The ruling shows that debtors can’t abuse the bankruptcy process by starting retirement plan contributions at the last minute.

The 6th Circuit referenced Section 541(b)(7) of the Bankruptcy Code, which says contributions made through employee payroll deduction to a benefit plan are exempt from a debtor’s bankruptcy estate and, most courts have found, a debtor’s disposable income, according to Lockman. However, the court found the exemption only applies if the debtor was already making these contributions during the six months prior to filing his bankruptcy petition.

Lockman speculates that the court applied the look-back rule because it is consistent with the definition of “current monthly income,” which considers a debtor’s average income over the six full months preceding bankruptcy, and other areas of the Bankruptcy Code that look back over time to protect creditors in case a debtor decides on the eve of filing for bankruptcy to do things to improve his situation at the expense of his creditors—for example, sell a car to his sister-in-law for a dollar or pay a debt owed to his brother on the eve of bankruptcy. Bankruptcy courts want to make sure all creditors get a fair shake. “That’s why the court looked back to see if the debtor in Penfound had been making contributions and didn’t just start to make them,” he says.

Lockman also speculates that the bankruptcy trustee went to the court about this issue because the debtor wanted to exclude more than $1,300 a month in retirement plan contributions. “If the amount was only $200 per month, I don’t think the trustee would have pursued it this far,” he says.

Applying the Rules for Planning Purposes

Consistent with the Dockins case, Lockman says, if a QDRO’s recipient keeps assets within a retirement plan, those assets would be protected, but if the recipient received a distribution of the funds, they would no longer be covered by ERISA’s anti-alienation provision.

“It’s a good rule to keep in mind for would-be debtors seeking to engage in exemption planning,” he says. “Keep assets if you anticipate having to file for bankruptcy.”

Itami says it is notable that in the Penfound case, the 6th Circuit didn’t mention ERISA anywhere in its opinion; it was not a factor. Even though the appellate court had previously allowed for 401(k) contributions to be considered “current monthly income” and protected from debtors in Davis, in Penfound it did not allow it because the petitioner was not making contributions in the six months prior to filing bankruptcy. “It’s about continuing to make contributions,” Itami says.

“The court said it didn’t care that the petitioner had changed jobs to an employer that didn’t offer a plan, meaning the petitioner could not make contributions,” she adds. “This is timely and interesting considering the number of people who are changing jobs right now.”