Dear Friends —
I had planned to post the winners of the book “50 Ways to Protect Your Identity and Your Credit” this week, but the Supreme Court just handed down a ruling that affects millions of us and it’s too important to ignore. If you wrote to me explaining why you need either the credit book or the Morningstar manual on selecting a mutual fund, please be patient. I haven’t forgotten! Winners of both will be announced shortly.
Important Notice for IRA Owners!
Your IRA is now off-limits to creditors in the event you file for bankruptcy protection.
What? You thought this was always the case? Not so! Up until April 5 your IRA had zero creditor protection under federal law. Instead, whether or not creditors could get their hands on your IRA assets depended on what state you live in. While New York had strict rules protecting IRAs in bankruptcy cases, other states, such as California, let the bankruptcy court decide how much of your IRA could be used to re-pay creditors.
Not only did the rules in all 50 states vary, the federal circuit courts also disagreed on this issue. While most said IRA accounts could not be attached in bankruptcy, the 8th Circuit in St. Louis repeatedly ruled they could -- a discrepancy Glenn Sulzer, Senior Tax Analyst at CCH, calls “pretty silly.”
The Supreme Court’s unanimous decision overrides both the states and lower courts and finally sets a uniform nationwide standard.
The case decided by the Court involved Richard and Betty Rousey, an Arkansas couple who had worked for Northrup Grumman. Under the terms of Northrup’s retirement plan, employees must empty their accounts when they leave the company. In the late 1990s Richard took early retirement and Betty was laid off, so they rolled a total of $55,000 into IRAs.
A couple of years later the Rouseys filed for bankruptcy.
Under federal bankruptcy law, assets that meet three conditions are exempt from creditor claims:
1) the money must be in “a stock bonus, pension, profit-sharing, annuity, or similar plan or contract;"
2) the right to receive payments must be “on account of illness, disability, death, age, or length of service;"
and 3) even then, the exempt amount is limited to what is “reasonably necessary to support” the person who owns the account and his/her dependents.
The bankruptcy court, the bankruptcy appeals panel, and the 8th Circuit Court of Appeals all ruled the Rouseys’ IRAs were fair game and could be used re-pay their creditors. In its decision, the circuit court said IRAs were more like savings accounts than retirement plans because you can access the money any time, even though you might have to pay a 10 percent penalty- something the circuit court dismissed as a “discouraging tax consequence.” (!)
So the Rouseys appealed to the next court in line- the U.S. Supreme Court. The Justices’ decision can only be described as “short and sweet.” They (sensibly) found that IRAs are not “savings accounts,” but retirement plans because, like pensions and profit-sharing plans, they are intended to provide income to replace the wages you would otherwise receive from work. Furthermore, distributions are affected by how old you are, death, and disability.
Unlike the lower courts, the Justices said that the 10 percent penalty is a significant deterrent to withdrawing money before age 59 ½. “The Rouseys no more have an unrestricted right to payment of the balance in their IRAs than a contracting party has an unrestricted right to breach a contract simply because the price of doing so is the payment of damages.”
Ed Slott, a CPA and author of “Parlay Your IRA into a Family Fortune,” calls the ruling “a big deal.” He predicts “a wave of IRA rollovers” from people who felt they had to leave their money in a former employer’s retirement plan just to get creditor protection.
It might even encourage people to make regular IRA contributions, says Slott, because now you know the money will be safe and “creditors can’t get to it.”
CCH’s Sulzer points out that the new bankruptcy bill making its way through Congress makes the Supreme Court’s decision even more important. The legislation, which is expected to be signed into law, will make it more difficult for people to walk away from their debts by filing for bankruptcy. “Without this ruling, people who lived in the 8th Circuit would have had even less protection for their IRAs.”
While everyone’s applauding this decision, it’s important to keep in mind that IRAs still do not have the same level of bankruptcy protection as 401(k)s, pensions, and profit-sharing plans, which are shielded from creditors under the federal law known as “ERISA.” Money in ERISA plans is essentially in a lock-box that only two entities can get into- the IRS and an ex-spouse. (No comment.)
One more thing. Because the Rousey case involved “traditional” IRAs (in which the money grows tax-deferred), some would argue that the Supreme Court’s decision only applies to these accounts. This would include IRAs used in SEP and SIMPLE retirement plans.
In other words, at this point it’s unclear whether Roth IRAs are extended the same protection.
Finally, did you notice something missing from the Supreme Court’s decision?
The Justices only dealt with the first two factors that determine whether an asset is exempt from creditors during a bankruptcy proceeding. In other words, since it was not being contested in this case, they did not define what amount meets the “reasonably necessary to support” criteria.
Most people would agree that $55,000 in IRA assets constitutes “necessary support” for a retired couple with little other income besides Social Security. But what about a million dollar IRA? Or a $5 million IRA? Accounts of this size are going to get more and more common as workers who have spent their careers contributing to 401(k)s rollover their plan balances when they retire.
Pessimists will argue that this is still an open issue subject to the discretion of the bankruptcy court. Optimists will say the Supreme Court made its “intent” clear and IRAs are off-limits to creditors — period. Realists will say we’ll be back in court some day where this issue will be tested.
At this point, I think it’s safe to assume that if you file for bankruptcy, unless you’ve got a multi-million dollar IRA, your creditors won’t be able to touch it— no matter where you live in these United States.
Score one for the little guys. And thank you, Richard and Betty Rousey!
Gail
P.S. Last week’s column contained a mathematical error. My thanks to Matt B. in Kalamazoo for pointing this out.
The issue concerns how much of the $30,000 contingent fee paid to the attorney who handled the case is deductible when calculating your federal income taxes.
The second-to-last paragraph, with the correction under-lined, should read:
According to CCH, a provider of tax law and software, legal fees that you incur because of this type of litigation are deductible as a “miscellaneous itemized expense.” So, to the extent they exceed 2 percent of your adjusted gross income, they will reduce the amount of your settlement that is subject to income tax. For example, assume your AGI was $100,000 and this was the only miscellaneous itemized expense you had. $100,000 x 2 percent = $2,000. This is the amount you cannot deduct. Thus, you would be able to deduct $28,000 out of the $30,000 you paid the attorney.
Keep in mind that your miscellaneous itemized deduction is reduced once your income hits a certain level. According to Mark Luscombe, senior tax analyst at CCH, for 2004 the magic number is $142,700; for 2005 it’s $145,950. These thresholds apply for everyone except those who file “married, separately; in that case the threshold is half the above amounts.
Moreover, if you’re unlucky enough to be caught in the AMT web, you can conceivably lose all or part of your miscellaneous itemized deductions.
The over-whelming number of emails I received came from folks who said the entire amount paid to the lawyer is an “above-the-line” deduction because of a change introduced by the American Jobs Creation Act of 2004. This is not correct.
Under this legislation, in order to take contingent legal fees as an above-the-line deduction your case must fall into one of three categories:
1) a claim of unlawful discrimination;
2) a claim against the federal government under Title 31 of the U.S. Code; or
3) a private cause of action under the Medicare Secondary Payer statute.
The case I described involved a single dad who worked for a private employer and who was fired for not wanting to work after-hours. Clearly, #2 and #3 do not apply.
Neither does #1. The factors which constitute “unlawful discrimination” would be such things as race, ethnicity, sex, and disability. The dad in this case did not claim his federal civil rights were violated. “Parenthood” is not a protected status.
Thanks for keeping me on my toes!
Gail
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