It’s very common in divorce settlements for retirement accounts to be divided between the spouses.

In a rather traditional situation, in which an empty-nest couple divorces after several decades of marriage, the husband would give up some portion of his 401(k) and/or his IRA to his non-working spouse.

In October 2018, in a case before the 8th Circuit Bankruptcy Appellate Court, a panel ruled that an IRA awarded in a divorce settlement is considered a property settlement and not a retirement asset.

Apparently, the panel made this ruling in reference to a 2014 Supreme Court decision (Clark vs. Rameker) which found that inherited IRAs are not protected under the bankruptcy code. The high court determined that retirement assets are defined as “sums of money set aside for the day an individual stops working.” Inherited IRAs do not strictly meet this definition. The direct implication is that an IRA awarded in a divorce settlement is not considered a “retirement account.” This stance puts traditional IRAs transferred in a divorce settlement in jeopardy in the event of a bankruptcy.

We should remember that employer-sponsored retirement plans (e.g. 401(k) or 403(b) plan accounts) are widely-protected under the 1974 Employee Retirement Income Security Act (ERISA). Under that federal law, company retirement plans are afforded protection from both bankruptcy and creditors. IRAs, however, are treated differently. Under the federal bankruptcy code, IRAs are protected up to $1,283,025. But, if an IRA is considered a property settlement and not a retirement plan asset, this protection does not apply.

Importantly, there is no federal protection of IRAs from creditors. IRA creditor protection is based on state law, which varies across the country. To be clear, general creditor protection involves claims other than bankruptcy.

So, if an IRA is considered not a retirement account and instead a property settlement, it is then exposed in a bankruptcy. While this recent ruling applies only in the 8th Circuit (Arkansas, Iowa, Nebraska, North Dakota and South Dakota), it should be recognized as potentially precedent-setting.

Also, we know that divorce is one of the leading causes of bankruptcy (other causes include medical expenses, job loss, and problems with consumer credit). Clients in fragile financial condition should think carefully about their settlement options in light of the panel’s ruling. Also, if IRAs are divided in a settlement, it is important that the awarded IRAs not be commingled with other IRAs which are not part of the settlement. It is possible that an IRA awarded in settlement could taint an IRA not part of the settlement, if it were to be combined with the non-settlement IRA.

Source: “Creditors Get the Ex’s IRA” by Ed Slott in Financial Planning (January 2019)

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