The 8th Circuit Bankruptcy Appellate Panel has issued a new opinion that is really causing a lot of anxiety and uncertainty about the exemption status in bankruptcy cases of retirement accounts awarded to debtors during a divorce case.
If a debtor is awarded a portion of their ex-spouse’s retirement account in a divorce proceeding, is that account protected in bankruptcy? Until a few months ago the majority opinion was yes, but that is all changed since the BAP issued the Lerbakken opinion.
In Lerbakken, the debtor was awarded one-half of his wife’s 401(k) retirement account in a divorce proceeding. He subsequently filed Chapter 7 and the bankruptcy trustee claimed his interest in the retirement. The bankruptcy judge ruled in favor of the trustee citing the United States Supreme Court’s opinion of Clark v Rameker, a case involving inherited IRA accounts.
To understand what the BAP was saying in Lerbakken, we need to review what the Supreme Court said about inherited IRA accounts in the Clarke opinion. In Clarke the Supreme Court said that inherited IRA accounts are not really “retirement funds” because they are designed more for current consumption than they are for future retirement needs. Why did the court say that? The court focused on 3 key differences between inherited IRA accounts and real retirement accounts:
- Additional Contributions: Inherited IRA accounts do not permit additional contributions. Traditional retirement accounts allow a person to make additional contributions so the fund grows in value during a person’s lifetime, but inherited IRA accounts do not. Thus, inherited IRA accounts do not appear to be focused on providing savings for the future.
- Required Withdrawals: Inherited IRA accounts require recipients to withdraw funds from the account. Instead of preserving the account for future retirement needs, an inherited IRA account requires the funds to be withdrawn, typically over five years.
- No Tax Penalties: There is no tax penalty for withdrawing money from an inherited IRA account. Traditional IRA accounts impose a 10% penalty for those who withdraw funds from the account when they are under age 59 & ½. Real retirement accounts penalize those who rob the nest egg, but inherited IRA accounts do not.
Given the features of inherited IRA accounts that encourage and even demand current consumption of the funds, the Supreme Court in Clark decided that such accounts do not meet the statutory definition of “retirement accounts” and, consequently, they are not protected by federal exemption laws (although such accounts might be protected under state exemption laws).
With this background in mind, let’s now return to the BAP’s opinion in Lerbakken.
In Lerbakken the BAP court takes the Clark opinion one dangerous step forward: “The opinion clearly suggests that the exemption is limited to individuals who create and contribute funds into the retirement account. Retirement funds obtained or received by any other means do not meet this definition.”
Did you get that? The BAP is saying that a Fourth Factor is implied in the Clark opinion–the exemption is limited to only those debtors who actually EARN and CONTRIBUTE the retirement funds. Accounts awarded to an ex-spouse in a divorce are not protected by the federal exemption because the ex-spouse did not earn or contribute the funds.
Wow! I’ve read the Clark opinion over and over again, and I just don’t see where the court “clearly suggests that the exemption is limited.” It does? Where? I cannot see a single line in that case “clearly suggesting” this result.
A retirement account received from a divorce settlement contains at least two of the three characteristics the Supreme Court focused on in Clark. Although debtors may not be able to make future contributions to retirement accounts divided in a divorce proceeding (what are referred to as a Qualified Domestic Relation Orders), they would be able to make future contributions if the account is converted to a Rollover IRA account. Also, debtors are not required to withdraw funds until they reach retirement age. Lastly, debtors do incur a 10% penalty if they withdraw funds before age 59 & ½. All three factors highlighted in Clark are present suggesting that the accounts are indeed “retirement funds.”
Under the BAP’s reasoning when a working parent contributes funds to a retirement account and the other parent is a stay-at-home mom or dad, all the funds in such accounts are protected for the working parent after a subsequent divorce but none of the stay-at-home parent’s funds are exempt. Apparently a stay-at-home parent does not “earn” or “contribute” to the couple’s retirement funds. This reasoning is flawed but it is now the rule in the 8th Circuit.
For 10 years my wife elected to step away from her career to devote full-time attention to our 3 children, and I’ll guarantee you that she “earned” and “contributed” as much to those retirement accounts during those years as I. The BAP’s opinion is not only wrong, it’s offensive.
WHAT ABOUT NEBRASKA’S STATE LAW EXEMPTION IN RETIREMENT FUNDS?
In addition to the federal exemption, debtors in Nebraska can take advantage of the state exemption law protecting retirement accounts (Neb. Statute §25-1552). Does Nebraska’s exemption law protect retirement accounts awarded to an ex-spouses in bankruptcy cases?
Maybe. We don’t know yet since there is no prior case answering this question. Nebraska’s exemption law seems broader, but it is also vague in many ways. So, the answer will depend on who is interpreting the statute. In theory it should not make a difference who the judge is, but in reality it makes all the difference in the world which is why nominations to our nation’s Supreme Court are such controversial events.
The Nebraska exemption law protects accounts reasonably necessary for the support of the debtor or the debtor’s dependents. Is an ex-spouse a dependent? Do you look to when the account was established or to when the bankruptcy was filed? Nobody knows, and debtor’s should be warned that their retirement accounts obtained in a divorce proceeding may not be protected in the bankruptcy process.
At some point a Chapter 7 Trustee will attempt to seize a large retirement account awarded to a divorced debtor, and then we will have a precedent to guide us. Until then, beware of filing Chapter 7 when a large retirement account awarded in divorce exist.