By Ian Berger, JD
IRA Analyst
Normally, if you declare bankruptcy, your IRA funds (traditional and Roth) are completely off limits to bankruptcy creditors. But a recent court decision is a good reminder that this isn’t always the case.
Bankruptcy protection for IRAs comes from the federal Bankruptcy Code. Under that law, up to $1,711,975 of annual IRA dollars are safe from bankruptcy creditors. (This maximum amount is effective through March 31, 2028). Importantly, the dollar limit does not take into account amounts you might roll over from company plans like 401(k)s. (The rolled-over plan dollars themselves are always fully protected under the Bankruptcy Code.) This means only IRA contributions and their earnings count towards the $1,711,975 limit.
Since IRAs did not become available until 1975, it would be unusual for someone to have amassed over $1.7 million from IRA contributions and earnings alone. So, in most cases, no IRA funds will need to be turned over to creditors if you file for bankruptcy.
However, there is one important exception to that rule. If your IRA loses its tax-exempt status, bankruptcy protection for that IRA disappears. When would this happen? The most common way is when a person in bankruptcy commits a “prohibited transaction” with his IRA dollars. Generally, a “prohibited transaction” is the improper use of IRA funds by the IRA owner, for example, through self-dealing. If you’re in bankruptcy and have significant IRA assets, you can bet your creditors will scrutinize every one of your IRA transactions in order to claim a prohibited transaction so they can seize your funds.
A recent court decision from the Eastern District of Pennsylvania illustrates another way that a person in bankruptcy can lose IRA creditor protection. In Stephanie Paula Farber v. Lynn E. Feldman, No. 2:22-cv-01817, Stephanie Farber inherited her father’s IRA worth about $41,000. In 2018, Farber used the $41,000 to open an IRA in her name at Wells Fargo. She subsequently rolled over the IRA to an individual retirement annuity with Allianz. The bankruptcy trustee (representing the creditors) contended that Farber funded her IRA with an amount that exceeded the annual IRA contribution limit in effect for 2018. (That limit was $6,500: $5,500 + $1,000 catch-up for age 50 or older). That caused the IRA to lose its tax-exempt status, according to the trustee.
The judge agreed. He found that, although Farber didn’t commit a prohibited transaction, she clearly made an excess contribution to her IRA. This prevented the IRA from being tax-exempt and prevented Farber from being able to shield those funds from her bankruptcy creditors.
Farber had originally claimed that she had simply transferred over the inherited IRA to Wells Fargo and then to Allianz. She likely changed her story because if she truly had an inherited IRA, it would not be protected from bankruptcy creditors under the unanimous decision of the U.S. Supreme Court inClark v. Rameker, 573 U.S. 122 (2014).
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/another-way-to-lose-ira-bankruptcy-protection/