IRA funds protected in bankruptcy

An Ohio bankruptcy court recently ruled that funds withdrawn from an individual retirement account and deposited in an individual’s business account were protected in bankruptcy. Despite the fact that the IRA distribution was not rolled over to another IRA, it didn’t prevent the funds from being exempt under the law.

IRAs are typically exempt from the bankruptcy estate. A bankruptcy exemption means the IRA is not part of the property that’s included in the bankruptcy estate and thus can’t be used to pay creditors. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the inflation-adjusted bankruptcy exemption for IRAs and Roth IRAs is $1,245,475. Company retirement plan funds, including SEP and Simple IRAs, are completely protected in bankruptcy. Further, if company plan funds are rolled over to an IRA, they are still fully protected in bankruptcy in an unlimited amount.

BAPCPA also includes a provision that protects retirement funds in transit from one plan or IRA to another. For example, if funds are withdrawn from an IRA, the law protects these funds while they are out of the IRA in transit to the new IRA or retirement account.

What happens, however, when retirement funds are ultimately distributed from a retirement account and not rolled over? Does their bankruptcy protection vanish, or do they retain their protected status? That was the issue before the Ohio Bankruptcy Court.

George and Deborah Karn (the debtors) operated an antiques and collectibles business as a sole proprietorship in Ohio. They maintained a business checking account at a bank under the name “Deborah E. Karn DBA D & D Antiques & Collectibles.” In August 2013 they withdrew about $39,000 from one of their IRAs, of which approximately $4,000 was withheld for federal income taxes. The remaining $35,000 was deposited into their business checking account. That account was used for both business and personal expenses.

Later that same year, the Karns filed for bankruptcy. They claimed an IRA bankruptcy exemption of about $24,000, which they said was the amount remaining from the IRA distribution that was deposited into their business checking account. The bankruptcy trustee objected, leading to a showdown in court.

STATE LAW

Under Ohio state law, debtors must use the state law exemptions because Ohio has opted out of the federal bankruptcy regime. However, BAPCPA still protects IRAs up to the current $1,245,475 limit. Thus, the protection of the Karns’ IRA relied partially upon federal law and partially upon state law. The Bankruptcy Court said it was clear that IRA assets are exempt, but the fact that the Karns took an IRA distribution, deposited it into their business account and used some of the funds made the exemption of the distributed funds less certain.

The bankruptcy trustee claimed that the Karns’ IRA funds were improperly commingled with nonexempt assets (the business checking account). The court found, however, that commingling exempt assets, such as an IRA, with nonexempt assets does not immediately result in the loss of a bankruptcy exemption under Ohio law.

The bankruptcy trustee also argued that the IRA funds were improperly used for the Karns’ antiques business, not for their retirement. The court disagreed because the location of the funds doesn’t determine whether they’re exempt property or not. Instead, the court turned to the question of whether the IRA withdrawal was used in retirement or used in a manner reasonably certain to benefit them in retirement. The court found that it was.

The trustee’s last argument was that IRA funds deposited into the business account no longer qualify as an IRA, and thus weren’t protected. The trustee argued that the IRA distribution lost its exempt status after the 60-day rollover deadline had passed. The court ruled that the funds distributed from the Karns’ IRA did not lose their bankruptcy exemption. The court reasoned that exemptions should be construed liberally and in favor of debtors and that it did not want to create a harmful new requirement for debtors.

While this case had a favorable result for the Karns, advisers should be careful about applying the conclusions in this case to clients in a similar situation. The Karns’ case was decided, in large part, based on state law and clients with a similar situation in a different state may not be as lucky.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.