IRA
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When Tracy Ponte’s father passed in 2015, she inherited the funds in his IRA account. Eight years later, in 2023, Tracy filed for Chapter 7 bankruptcy protection. Her schedules listed that IRA account, known as the “Inherited IRA”, and also another retirement account known as her “Personal IRA”. There was a little over $55,000 in the Inherited IRA and a little over $80,000 in the Personal IRA. How Tracy’s Personal IRA came about requires further examination.
Tracy established the Personal IRA in 2022 at a local federal credit union, and indicated in the application that the funds were to come from a rollover “from a Roth IRA or eligible employer sponsored retirement plan…” Tracy then deposited $80,000 into a traditional savings account and $10,000 into an account for the Tracy Ponte PAS Family Trust account. The $80,000 was then transferred from the savings account into the Personal IRA as a “rollover contribution”. In reality, none of the total of $90,000 in funds came from any kind of retirement plan, but instead it all came to Tracy from her ex-spouse as part of a divorce settlement the previous year, being 2021.
Tracy’s bankruptcy schedules claimed both of these accounts as exempt under both federal bankruptcy law and California law. The Bankruptcy Trustee took issue with these claims of exemptions and filed an objection. The U.S. Bankruptcy Court for the Northern District of California held at least two hearings on Tracy’s claim of exemption and asked for supplemental briefing on the issues from the parties. Eventually, the bankruptcy court issued the opinion next to be discussed in the case of In re Ponte, 2024 WL 559763 (Bk.N.D.Cal., Feb. 8, 2024).
The court started out with the basics. When somebody files for bankruptcy, all of their assets become property of the bankruptcy estate under Bankruptcy Code § 541(a). However, a debtor may then claim an exemption for property which is protected by either the Bankruptcy Code or the law of the state where the debtor is resident at the commencement of the bankruptcy case.
The Bankruptcy Code itself exempts so-called “qualified” retirement accounts, meaning that they are retirement accounts that are tax-exempt under the Internal Revenue Code. Such “qualified” retirement accounts that are exempt include both traditional and Roth IRAs.
Now here comes a curveball that a lot of folks don’t understand. The Bankruptcy Code says that each state can “opt out” of the Bankruptcy Code’s exemption scheme (including for qualified accounts such as IRAs) and instead replace those exemptions with state exemptions. Here, Tracy was in California, and California is one of the states that has opted out of the Bankruptcy Code’s exemption scheme. As to qualified accounts, the California alternative scheme protects: “”The debtor’s right to receive … a payment under a stock bonus, pension, profitsharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor…”
Yet, after that curveball comes a knuckleball, which is that even if a debtor’s state has opted out of the bankruptcy exemption scheme, there still still protection for IRAs under the Bankruptcy Code. In other words, a state exemption scheme can trump the bankruptcy scheme if the state has opted out, but the bankruptcy protections specific to IRAs (up to a certain dollar limit not relevant here) then trump the state exemption scheme.
Note that in any event, it is the debtor who has the burden of proving a right to the exemption claimed by the debtor. So, while a trustee may be the one who files the challenge to the claim of exemption, at the end of the day it is still the debtor who has to prove it up. It was thus up to Tracy to prove that the Inherited IRA and Personal IRA were exempt, and the court started with the first of these.
Here, the court goes through a detailed discussion of what constitutes an IRA, but basically comes down to the fact that it is meant to be a retirement account that is protected from creditors so that a person will have the means to live on in retirement. However, with the bankruptcy court nodding to the ruling of the U.S. Supreme Court in Clark v. Rameker, 573 U.S. 122, 124 (2014), the court then noted that once the holder of the account dies away, the account essentially just becomes another pile of money that is no longer protected from creditors (with the exception that a surviving spouse may roll over the decedent’s IRA funds into their own IRA for their own retirement purposes). Therefore, since Tracy was not a surviving spouse, since she had inherited the IRA from her father, the Inherited IRA was not exempt under the Bankruptcy Code.
If the Bankruptcy Code did not provide an exemption, Tracy then had to prove that California law created an exemption for the Inherited IRA. The problem here, though, was the same: The Inherited IRA did not qualify for the California exemption because it did not come about as a result of Tracy funding her retirement and Tracy had access to the funds (without a penalty) prior to her own retirement. So, the Inherited IRA would not be exempt.
That now brings us to Tracy’s Personal IRA. The court noted that to qualify for a creditor exemption, an IRA must both consist of retirement funds and also be tax exempt under the Internal Revenue Code. As to the latter, the IRC imposes limits on how much may be annually contributed to the IRA and an amount above that limit (known as an excess contribution) would not be tax exempt and thus not creditor exempt either.
No matter how Tracy desired to characterize it, her $80,000 was not anything like a rollover contribution from another plan since the source of that money as an equalization payment arising from her divorce. What Tracy could properly have contributed to an IRA was only $7,000 and so the difference of $73,000 was an excess contribution. Thus, the court found that only $7,000 was exempt and the remaining $73,000 could not be exempted.
The bottom line of all this was that the Trustee’s objection to Tracy’s exemption claim was sustained in its entirety as to the Inherited IRA and as to all but $7,000 of the Personal IRA.
ANALYSIS
The creditor exemptions for IRAs are often difficult for many folks, including many advanced planners, to fully understand. There are good reasons for this, mainly that the bankruptcy exemptions overlap only imperfectly with the state exemptions, there may be (as in this case with California) different IRA exemption schemes for different circumstances, the state exemptions are all over the board state-by-state with only coincidental consistency where it exists at all, and finally these exemptions usually also require reference to the Internal Revenue Code to determine if a particular account is protected at all. Trying to explain all this is well beyond the scope of the article, but the point is that it is that all this can be sublimely confusing and thus must not be generalized. Instead, in each case, a substantial examination of each IRA account under the particular circumstances must be made.
When it comes to Inherited IRAs, what should be understood is that when the account owner dies, for creditor-debtor purposes all that remains is just a pile of money, or just an ordinary account if you prefer, that goes to heirs. Any creditor exemption that protected the IRA from the decedent’s creditors does not transfer to surviving beneficiary of the account (unless that beneficiary is the decedent’s spouse). That beneficiary will effectively just be taking cash that is not protected from creditors.
Note that the account owner can take steps to protect the money from the beneficiary’s creditors, such as by providing that the money will pass to the beneficiary by way of a spendthrift trust. That is what the account owner can do prior to death, but there is nothing that a beneficiary can do to make an Inherited IRA exempt other than to urge the account owner to make such provisions while there is still time.
The next lesson in this case is that a debtor cannot overfund an IRA or any other type of qualified account and expect that the overfunded amount will be protected from creditors. Many creditors will scrutinize a debtor’s IRA, particularly if sizeable, looking for a violation of the Internal Revenue Code such as would result in all or part of the IRA losing its exemption. For this and other reasons, when I am representing debtors I often advise them to start using their IRA funds for expenses so as to reduce the IRA amount as much as possible.
For asset protection planning purposes, suffice it to say that I am no fan of IRAs. If somebody wants their retirement funds to be protected, it is preferable for those accounts to be some sort of ERISA-protected account since there is the additional protection of ERISA’s anti-alienation provisions in addition to any exemptions.
One last thing about IRA exemptions, and in fact exemptions generally: The exemption law that protects the asset of a debtor will be that law of the state where they are resident when the creditor attempts execution upon the asset or when a bankruptcy case is commenced for the debtor. Thus, a person who moves across state lines will likely find that the creditor protection for their IRA will have weakened or strengthened after the move. I’ve seen many instances where a debtor thought that their IRA was protected because they were told it was under the laws of the state they lived in when it was created, but when they moved their IRA lost some or all of its protection and nobody warned them about that.
Anyway, let this opinion be a warning about IRAs that are inherited or overfunded.
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