This post deals with protecting IRAs in bankruptcy – and the IRA was ultimately protected – but the arguments made are ones that only an ERISA junkie might appreciate.
1. IRAs are protected in bankruptcy only if the IRAs are tax exempt.
2. IRAs are tax exempt only if they do not engage in prohibited transactions.
3. One prohibited transaction is the direct or indirect loan between the IRA owner and a party in interest, such as the bank or other financial institution that holds the IRA assets (IRA Custodian).
4. The Department of Labor (DOL) has the authority to decide what constitutes a prohibited transaction.
5. Recently the DOL declared that boilerplate provisions in IRA account documents that allow the IRA Custodian to offset amounts in the IRA against debts owed to the IRA Custodian by the IRA owner constitute a prohibited loan.
6. IRA Custodians and IRA owners were surprised at this ruling: Most account documents have this language so most IRA accounts would lose their tax exempt status. The DOL said that it would study the issue.
7. The IRS said that while the DOL was studying the issue, the IRS would not treat IRAs as violating prohibited transaction rules because of these statements in the account documents so long as no IRA assets are actually offset.
8. The DOL issued a proposed prohibited transaction exemption that will allow this language only until six months after the prohibited transaction exemption is issued in final form. By that date, the language must be removed from account documents.
9. A debtor with a rollover IRA account filed for bankruptcy. The IRA account contained the boilerplate language. The debtor had no other accounts with the IRA Custodian and the offset was never used.
10. Based upon the DOL’s position that the existence of the boilerplate language is a prohibited transaction, the bankruptcy trustee claimed that the assets in the IRA should not be protected in bankruptcy.
11. The Sixth Circuit Court of Appeals ruled that the IRA would be protected. The court concluded that because the debtor had no other account with the IRA Custodian, there was no way in which the improper offset could have occurred. The court also noted that the IRS had said that it would not revoke the tax exemption of IRAs with this provision during the time that the DOL was considering the issue.
12. The technical argument loses.
Although the debtor in this case was able to protect the IRA, the reasoning of the case suggests that if the individual had had another account with the IRA Custodian, perhaps the IRA would not have been protected. Since Congress allows IRAs to be protected in bankruptcy and since this boilerplate language has been in account documents for decades without any hint that the IRS would disqualify the account because of the provision, we can hope that other courts faced with this question will reach a similar conclusion and protect the IRA in bankruptcy.