No one really plans to file bankruptcy. It’s one of those things that just happens to some people. On the other hand, lots of people, though still too few, do plan their estates and for retirement. Sometimes bankruptcy and estate planning collide. Usually the collision isn’t harmful to the retirement account. But it can be.
In Utah there are two sets of exemptions for retirement accounts. The first is the exemption provided by state law, which exempts the contents of a retirement account from creditors’ claims to the extent the funds in the account were deposited more than one year prior to filing bankruptcy. The second exemption exists under federal bankruptcy law and exempts all retirement accounts, regardless of when the contributions were made. Utah has “opted-out” of the federal exemption scheme for the most part, but whether intentional or inadvertent, the Utah legislature left the federal retirement exemption applicable.
Under federal law, most retirement accounts are fully exempt. There are two requirements for an account to meet the standards of the federal law: first, the funds in the account must be “retirement funds.” Secondly, the account must be an account that qualifies for tax-exemption under various provisions of the Internal Revenue Code. A recent case from Minnesota has cast some doubt on what are “retirement funds.” In In re: Lerbakken, Bankruptcy Appellate Panel for the Eighth Circuit Court of Appeals held that funds that Mr. Lerbakken received from his ex-wife’s retirement account as part of their divorce settlement and which he promptly deposited to his own IRA were not “retirement funds.” Relying on a 2014 Supreme Court case, the appellate panel said that retirement funds are those funds created by and deposited by the person claiming the funds as retirement funds. In other words, since Mr. Lerbakken’s ex-wife created the funds from her employment, they couldn’t qualify as his retirement funds.
This ruling, if it becomes a prevailing view, has the potential to wreak havoc when estate planning and bankruptcy collide. Mr. Lerbakken received the settlement in 2014 and commingled those funds with his own. He filed bankruptcy four years later. Sorting out what portion of his IRA is attributable to his own earnings and what portion came from Mrs. Lerbakken’s is only one headache. Another is how to plan for or at least address such a possibility. As I said, no one plans to file bankruptcy; it just happens. But if it does, what, if anything, can be done to address this problem? It’s a question that for now doesn’t have a good answer.