Creditors Cannot Reach Certain Retirement Plan Interests
In 1992, the United States Supreme Court resolved a long-standing conflict in the federal courts regarding whether a debtor’s retirement plan could be used to satisfy the claims of creditors in bankruptcy proceedings. The Court held that creditors could not reach a debtor’s interest in a plan qualified by the Employee Retirement Income Security Act (ERISA).
The Bankruptcy Estate and Section 541(c)(2)
Upon the filing of a bankruptcy petition, a bankruptcy estate is created from the assets of the debtor. In a Chapter 7 case, all non-exempt property of the estate is liquidated (sold, or otherwise converted to cash) in order to pay the claims of creditors. However, creditors cannot reach property of the debtor that is not part of the bankruptcy estate.
The Bankruptcy Code broadly defines “property of the estate.” Generally, the estate consists of all the legal and equitable interests of the debtor as of the time the petition was filed. However, Section 541(c)(2) provides an exclusion from this otherwise broad definition – it allows a debtor to exclude from the estate (and therefore protect from the claims of creditors) any interest in a plan or trust that contains a transfer restriction “enforceable under applicable nonbankruptcy law.”
The Supreme Court was asked to interpret the “applicable nonbankruptcy law” language used in the latter provision, because inconsistent interpretations had emanated from the lower federal courts. Some courts had determined that the phrase referred only to state law, and not to federal law. In contrast, other courts had found that both federal and state law were included within the scope of the “nonbankruptcy” language.
Debtor Seeks to Protect Pension Plan
This case was initiated by an individual debtor who filed for protection under Chapter 7 of the Bankruptcy Code. Before he filed for bankruptcy, the debtor had participated in his employer’s pension plan for 30 years. Among other provisions required by ERISA (federal law), the pension plan contained an anti-alienation provision that essentially prohibited the pension benefits from being transferred.
When the bankruptcy trustee sought to make the debtor’s ERISA-qualified pension plan part of the bankruptcy estate (and therefore available to satisfy the claims of the debtor’s creditors), the debtor argued that Section 541(c)(2) operated to exclude the pension plan from his estate. Specifically, the debtor urged the court to interpret Section 541(c)(2) to include both federal and state law. That way, the ERISA-required transfer restriction in the pension plan would be an “applicable nonbankruptcy law” sufficient to keep the plan out of the bankruptcy estate.
The Court of Appeals for the Fourth Circuit agreed with the debtor. Specifically, the court found that the ERISA requirement constituted an “applicable nonbankruptcy law” and the pension plan should therefore be excluded from the bankruptcy estate.
The Supreme Court Decision
On appeal, the U.S. Supreme Court looked to the plain language of Section 541(c)(2) and concluded that nothing in the statute indicated that the phrase “applicable nonbankruptcy law” referred exclusively to state law. In other words, the Court held that the provision encompassed any relevant nonbankruptcy law, including federal law such as ERISA. The Court also examined other sections of the Bankruptcy Code and determined that the interpretation that included federal as well as state law was consistent with other references in the code to sources of law.
After the Court concluded that “applicable nonbankruptcy law” was not limited to state law, it further determined that the anti-alienation provision included in the debtor’s ERISA-qualified pension plan satisfied the literal terms of the Section 541(c)(2). Therefore, because the pension plan contained an enforceable transfer restriction for purposes of Section 541(c)(2), the pension plan was properly excluded from the bankruptcy estate.
Supreme Court Extends Protection to IRAs
On April 4, 2005, the U.S. Supreme Court ruled that Individual Retirement Accounts (IRAs) are similarly protected in bankruptcy. Some lower courts had ruled that IRAs were not entitled to the same protection in bankruptcy as pension plans and 401(k)s, since IRAs permit withdrawals at any time for any reason, as long as holders under the age of 59 and 1/2 pay a ten percent penalty. However, the Court reasoned that “that penalty erects a substantial barrier to early withdrawal” and in a unanimous decision, the Court determined that IRAs should receive the same protection from creditors in bankruptcy as pension plans, 401(k)s, Social Security and other benefits related to the age, disability or illness of the debtor.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)
The enactment of BAPCPA amended the bankruptcy code to exempt from the bankruptcy estate assets in and payments from non-ERISA tax qualified plans, including traditional and Roth IRAs, 403(b) and 457 plans. The debtor must establish that the fund from which they are payable is tax exempt, either by providing a determination letter, if one is available, or by demonstrating that an adverse ruling as to the fund’s tax-exempt status by the IRS or a court does not exist.
Under BAPCPA, direct transfers and eliglble rollovers within a 60-day period to and from these plans are exempt from the bankruptcy estate. The exemption for amounts in traditional or Roth IRAs is limited to $1 million (exclusive of rollover contributions), although this amount is subject to increase under the law in certain circumstances.
Contributions to ERISA plans, Section 457 deferred compensation plans, Section 414(d) government plans and Section 403(b) tax-deferred annuities that are withheld by the employer from the employee’s wages, or amounts received by an employer as a result of employee contributions to a plan, are automatically excluded from the bankruptcy estate.
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