Surprising to many, qualified retirement accounts received by a spouse in divorce may lose creditor protection, a significant beneficial feature of retirement accounts. In the case of In re Lerbakken, filed on October 16, 2018, the Bankruptcy Appellate Panel of the Eighth Circuit held that qualified accounts received by the non-participant spouse pursuant to a qualified domestic relations order are subject to creditors in bankruptcy.1 If this view is adopted around the country, it represents a critically important development at the intersection of divorce and asset protection planning.
Clark v. Rameker
In the Clark case, a unanimous U.S. Supreme Court held that funds in an inherited IRA were not protected from a bankruptcy debtor’s creditors even though funds held in qualified retirement accounts typically benefit from creditor protection.2 The distinction revolves around the definition of “retirement funds” which are protected from creditors in bankruptcy.3
Although a debtor’s assets typically become part of his or her bankruptcy estate upon the filing of a bankruptcy petition, certain assets are exempt.4 One of the exempt assets relates to “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under Section 401, 503, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code”.5 This statute requires that funds in such accounts qualify as “retirement funds,” which was the critical question of the case. In analyzing the question, the Supreme Court cited to three significant differences between one’s own retirement account and an inherited retirement account:
- “The holder of an inherited IRA may never invest additional money in the account;”6
- “Holders of inherited IRAs are required to withdraw money from such accounts no matter how many years they may be from retirement…that the tax rules governing inherited IRAs routinely lead to their diminution over time, regardless of the holders’ proximity to retirement, is hardly a feature one would expect of an account set aside for retirement;”7 and
- “The holder of an inherited IRA may withdraw the entire balance of the account at any time – and for any purpose – without penalty.”8 Alternatively, a participant may not withdraw funds before age 59 ½ without incurring a 10% tax penalty, meaning that inherited funds constitute “a pot of money that can be freely used for current consumption.”9
After discussing these differences, the Court noted that “nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete,” thereby violating the Bankruptcy Code’s purpose of preserving a debtor’s ability to meet their basic needs after a fresh start.10
In the end, the Supreme Court found it important that funds in qualified accounts not merely be tax-exempt under the relevant provisions of the Internal Revenue Code, but also that they constitute “retirement funds.” Under the plain meaning of “retirement funds,” and the Court’s interpretation of the statute and legislative intent, the Court ultimately found that inherited IRAs do not qualify as an exempt asset under the federal bankruptcy exemption statute.
Qualified Domestic Relations Orders (“QDRO”)
A QDRO is a judgment, decree, or order relating to the provision of child support, alimony, or marital property rights which creates or recognizes an alternate payee’s rights to receive all or a portion of benefits otherwise payable to the participant under a qualified retirement account, which is entered into before there is a distribution to the alternate payee.11 QDROs are an exception to the rules prohibiting assignment or alienation of benefits under qualified retirement plans.12 “Alternate payees” under a QDRO may be a spouse, former spouse, child, or other dependent of a participant.13
To qualify, the QDRO must contain:
- The name and last known mailing address of the participant and each alternate payee;
- The amount or percentage of the participant’s benefits to be paid to each alternate payee or the manner in which the amount or percentage will be determined;
- The number of payments or the period to which the order applies; and
- Each plan to which the order applies.14
A QDRO may not:
- Require a plan to provide any type or form of benefit, or any option, not otherwise provided under the plan;
- Require the plan to provide increased benefits (based on actuarial values); or
- Require the payment of benefits to an alternate payee which are required to be paid to another alternate payee under another previously determined QDRO.15
A QDRO may provide for early retirement benefits to the alternate payee, even though the participant spouse has not separated from service.16 The result of this, for example, is that a plan which provides that participants may retire at age 55 and begin receiving benefits may be required to begin payments to the alternate payee at age 55 even if the participant spouse remains employed. In addition, with respect to benefits accrued at the time of divorce, a QDRO may require a former spouse to be treated as the participant’s spouse for purpose of the spousal annuity rules.17
Assuming the requirements are met, under a QDRO a former spouse will generally be treated as a spouse of the participant of the retirement account to determine the alternate payee’s required begin date, with payments allowed over the life expectancy of the alternate payee.18
In re Lerbakken
Brian Lerbakken filed for Chapter 7 bankruptcy protection on January 23, 2018, claiming his interests a 401(k) and IRA received in a QDRO qualified as assets exempt from his creditors under the federal bankruptcy exemption.19 Lerbakken’s former law firm, which represented him in his divorce, contested this treatment in seeking to recover unpaid legal fees.20 As such, the issue before the Court was whether these accounts should be treated as a participant’s own account for bankruptcy purposes or, alternatively, like inherited accounts under Clark. The bankruptcy court disallowed the exemption by finding the accounts not to be “retirement funds.”21
In discussing the legal question, the Court first noted that two statutory requirements must be met: “(1) that the amount must be retirement funds; and (2) that the retirement funds must be in an account that is exempt from taxation under one of the provisions of the Internal Revenue Code set forth therein.”22 The Court cited to Clark’s reasoning that terms should be given their plain reading and that courts should make an objective finding rather than engage in a case-by-case factual analysis.23 In so stating, the Eighth Circuit stated that Clark “clearly suggests that the exemption is limited to individuals who create and contribute funds into the retirement account.”24 The Court found that any interest Lerbakken held “resulted in nothing more than a property settlement.”25 As such, the funds were not retirement funds qualified as exempt under federal law.
While the decision in Lerbakken may not be too far removed from the Clark case, there are some significant differences between inherited accounts and QDRO accounts. As cited above, the Supreme Court referenced three differences between an inherited account and a participant account. Only one of those three distinctions apply to a QDRO account – the holder may never have contributed funds to the account. However, the other two distinctions cited by the Supreme Court do not apply to QDRO accounts. As a result, funds in a QDRO account are not typically available to the individual to use “the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.”26
Another difference between an inherited account and a QDRO account is that the couple, while married, used the account to save for their joint retirement. This issue was argued by Brian Lerbakken.27 While the Eighth Circuit felt that this distinction would require it to get in to case-by-case, fact intensive analytics about the purposes of the account, it seems fairly, objectively different than an account inherited by a non-spouse designated beneficiary. Frequently, one spouse is a higher income earner than another spouse. However, in many marriages, spouses share financial responsibility for retirement savings. Imagine a scenario where one spouse works in the home while the other is the wage earner, contributing to a qualified retirement account intended to support the couple in retirement. If they later divorce and the non-participant spouse receives some or all of the account under a QDRO, the funds are not retirement funds? That seems highly dubious on its face. However, that is exactly what the Eighth Circuit found.
With respect to inherited accounts, the Supreme Court in Clark seems to have made a distinction between non-spouse designated beneficiaries and spouse. The Court specifically noted the ability of a surviving spouse named as a designated beneficiary to “roll over” the account into his or her own account.28 A rollover account would operate much more similar to a QDRO account than an inherited account (again, see the three differences in one’s own account and an inherited account cited above). Did the Supreme Court intend to find rollover accounts to be “retirement funds” for bankruptcy purposes? Did the Supreme Court intend to distinguish accounts subject to the three cited differences from ones which are not (for example, can the beneficiary withdraw funds to pay for a vacation immediately after bankruptcy)? In either event, it seems that the Lerbakken court would not have been bound to find a QDRO account fails to qualify as “retirement funds.”
Time will tell whether the result in Lerbakken becomes the law of the land. However, until there is a definitive answer to that question, planners outside of the Eighth Circuit likely should plan based on the possibility that QDRO accounts are subject to claims of creditors under the federal bankruptcy exemption statutes.29
Following the Lerbakken opinion and tax law changes in divorce under the Tax Cuts and Jobs Act, the landscape for negotiating divorce settlements has significantly shifted. It will be important for tax, accounting, financial, and other professionals to consider these changes in negotiating divorce settlements.30
- In re Lerbakken, — B.R. —, 2018 WL 4996146 (6th Cir. 2018).
- Clark v. Rameker, 134 S. Ct. 2242 (2014).
- 11 U.S.C. §522(b)(3)(C)
- 11 U.S.C. §541(a)(1)
- Supra note 3 and 11 U.S.C. §522(d)(12)
- Clark, 134 S. Ct. at 2247.
- Id. at 2248.
- IRC §414(p)(1); and Rodoni, Mario, 105 T.C. 29 (1995).
- IRC §401(a)(13)
- IRC §414(p)(8)
- IRC §414(p)(2)
- IRC §414(p)(3)
- IRC §414(p)(4)
- IRC §414(p)(5)
- Treas. Reg. §1.401(a)(9)-8, Q&A 6
- Lerbakken, 2018 WL 4996146, at *1.
- Id. citing 11 U.S.C. 522(d)(12) and Rice v. Allard, 478 B.R. 275, 280 (E.D. Mich. 2012).
- Lerbakken, 2018 WL 4996146, at *2.
- See Clark at 2248.
- See Lerbakken, 2018 WL 4996146, at *2.
- See Clark at 2245.
- An important point in this is to know that debtors in bankruptcy may elect either federal or state exemptions. Many states specifically protect retirement accounts much more broadly than the federal exemption statutes. Therefore, notwithstanding the Lerbakken opinion, depending on where the debtor resides, protection of the account still may be possible.
- Effective in 2019, the TCJA repealed the deduction for alimony payments and the ability to tax a former spouse on distributions from a trust to him or her. Instead, the grantor-spouse who does not receive the distribution remains taxable on the income).