On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the Bankruptcy Act of 2005). This enactment concludes a longstanding legislative effort to tighten bankruptcy statutes and to make it more difficult for consumers to discharge certain debts by filing for bankruptcy protection. However, while some provisions of the Bankruptcy Act of 2005 restrict debtor options in bankruptcy, this legislation also provides new protections for assets in certain retirement savings arrangements.
The provisions of the Bankruptcy Act of 2005 are generally effective for bankruptcy petitions filed 180 or more days after the date of enactment (i.e., after October 17, 2005).
What Assets Does the Bankruptcy Act of 2005 Protect?
IRAs and Employer-Sponsored Retirement Plans
The new bankruptcy protections include assets in IRAs (Traditional and Roth), IRA-based employer plans, including savings incentive match plan for employees of small employers (SIMPLE) IRA plans and simplified employee pension (SEP) plans, and most employer-sponsored retirement plans. Assets rolled over from employer-sponsored retirement plans (including SIMPLE IRA plans) to IRAs are also given protection in bankruptcy proceedings.
Coverdell Education Savings Account (ESAs) assets and Internal Revenue Code (IRC) Sec. 529 college savings/tuition plan assets are also given protection, with special limitations based on the timing of contributions in relation to a debtor’s bankruptcy filing.
Exemption, Exclusion, and State vs. Federal Choices
When an individual (a debtor) files for bankruptcy relief, federal law dictates that most of the debtor’s property be included in the bankruptcy estate. A trustee is appointed to gather the debtor’s assets for distribution to creditors that have claims against the debtor. Federal law allows debtors to protect certain assets by exempting them from the bankruptcy estate. Exempting an asset means that a debtor can carve out certain property from the bankruptcy estate and protect that asset from creditors’ claims. Exempt assets under federal law include the debtor’s interest in a home or car, for example, provided the interest does not exceed a certain value.
Federal law also permits states to create their own list of exemptions that debtors can use instead of the federal exemptions. States may allow debtors to choose between the federal or state exemptions, or they may require debtors to use the exemptions provided by the state in which the bankruptcy petition is filed. In states that offer a choice, debtors will typically elect whichever exemptions—federal or state—protect the most property. Many states provide specific exemptions of IRA assets; the federal exemption laws (before the enactment of the Bankruptcy Act of 2005) did not.
Exclusion of assets from a bankruptcy estate, on the other hand, means that an asset is never included in the bankruptcy estate. Before the Bankruptcy Act of 2005 was enacted, debtors who wanted to protect employer-sponsored retirement plan assets often relied on the 1992 Supreme Court ruling in Patterson v. Shumate (504 U.S. 753) to exclude retirement plan assets from their bankruptcy estates. In Patterson, the Supreme Court ruled that antialienation provisions in Mr. Shumate’s “ERISA-qualified” retirement plan had to be given effect under the bankruptcy rules. ERISA (the Employee Retirement Income Security Act of 1974) prohibits the assigning of benefits—even to a bankruptcy trustee. Therefore, the retirement assets in that case were excluded from the bankruptcy estate, based on a specific exclusion in the bankruptcy code.
Automatic Federal Exemption for Retirement Savings, Exclusion for Education Savings
Debtors with employer-sponsored retirement plan assets no longer have to rely on the Patterson case to protect employer-sponsored retirement plan assets in bankruptcy. The Bankruptcy Act of 2005 automatically exempts any amount of such assets regardless of whether the individual filing the bankruptcy petition chooses state or federal bankruptcy exemptions. IRA assets up to $1 million are also exempted from a bankruptcy estate, again, regardless of whether the debtor chooses the state or federal bankruptcy exemptions. Education savings assets, as explained later in this article, are automatically excluded from a bankruptcy estate, subject to certain conditions.
Degree of Protection for Traditional and Roth IRAs, and for Employer Plans
The Bankruptcy Act of 2005 provides the following protections.
IRAs, IRA-based plans: Assets in Traditional or Roth IRAs, other than assets attributable to rollovers, and other than SEP or SIMPLE IRA assets, are subject to a $1 million exemption limit.
Indexing: The $1 million limit may be increased, based on a review of the Consumer Price Index (CPI), every three years.
SEP, SIMPLE IRA assets: SEP and SIMPLE IRA plan assets have unlimited protection.
Most employer plans protected: A debtor may protect retirement assets in a fund or account that is exempt from taxation under IRC Sec. 401, 403, 408, 408A, 414, 457 or 501(a), which includes, but is not limited to, profit sharing plans, 401(k) plans, tax-sheltered annuities, certain government plans and plans of tax-exempt organizations.
Assets in transit: Assets moving from one arrangement to another are protected (e.g., in an indirect rollover, which has a 60-day period to complete the transaction, etc.).
Plan loans not discharged: In bankruptcy, certain obligations of the debtor may be discharged or, essentially, forgiven. Plan loans are not dischargeable in bankruptcy. If a plan loan is being repaid through payroll deduction, there is no automatic stay; therefore, deductions can continue, and repayment amounts will not be considered “disposable income” for bankruptcy purposes. This provision helps the debtor to keep loan payments out of the reach of creditors. However, loan terms may not be materially changed, presumably to prevent the debtor, for example, from increasing repayment amounts to shield more income from creditors.
Education Savings Exclusion, Not Exemption
The Bankruptcy Act of 2005 automatically excludes Coverdell Education Savings Accounts (ESAs) and IRC Sec. 529 college savings/tuition plan assets from a debtor’s bankruptcy estate, subject to certain conditions.
The conditions placed on education savings protections are as follows.
No protection is given to amounts that would be considered excess contributions.
Amounts contributed within one year before a bankruptcy filing are not protected.
Amounts contributed between one year and 720 days before a bankruptcy filing are protected to a maximum of $5,000. This applies to both ESAs and 529 plans.
Only amounts contributed on behalf of a child, stepchild, grandchild or stepgrandchild may be protected. (This definition includes children legally adopted, those placed for legal adoption, or a foster child residing principally with the debtor.
An ESA that has been pledged in any borrowing arrangement is not protected.
While it is generally believed that the Bankruptcy Act of 2005 will make it harder for many Americans to discharge debt through a bankruptcy filing, the above-described provisions of the Act have the opposite effect. They codify some ERISA-governed plan protections that have been available since Patterson v. Shumate, clarify protections for assets moving between plans, provide protection of IRA and IRA-based plan assets, and add protection for education savings assets.