Two recent developments with regard to bankruptcy are substantially changing the landscape regarding the attractiveness of IRA rollovers for employees with large accounts in tax-qualified plans.
Until now, there has been inconsistency among jurisdictions as to whether an IRA would be included in a bankruptcy estate if a participant were to become bankrupt. Some participants in qualified plans, upon becoming entitled to receive a plan distribution by virtue of their separation from service or their age or other plan rules, chose to leave their accounts with a qualified plan trustee, even though they might have preferred an IRA rollover, simply because they thought that the qualified plan offered greater protection against claims of creditors. As a result, some qualified plans of small businesses have been kept alive after the sponsoring employer ceased to be in active business, and some qualified plans of larger businesses have been made to retain accounts of individuals long since gone.
Supreme Court Decision
On April 4, 2005, the Supreme Court took a major step to resolve the inconsistency among the courts. In Rousey v. Jacoway, the Court held that IRAs will be excluded from the bankruptcy estate to the extent reasonably necessary for support.
This issue was controversial because an IRA, although held in a separate trust for retirement, can legally be withdrawn before retirement, albeit with tax penalties. The bankruptcy law exempts payments that are made "on account of illness, disability, death, age or length of service." Some lower courts thought that because an IRA could be withdrawn at any time, the payments from an IRA did not meet this exemption standard. Other lower courts took the view, now confirmed by the Supreme Court, that an IRA's assets did sufficiently meet this standard. Under the bankruptcy law, as interpreted in this case, an IRA does not get automatic exclusion from the bankruptcy estate. Rather, it becomes subject, along with all other retirement savings of the bankrupt person, to the test of whether the funds are "reasonably necessary for the support of the debtor and any dependent." This test is applied by the bankruptcy court, not the parties. It may seem axiomatic that, for a person who files a bankruptcy petition, the funds in an IRA will be necessary for support. In the case of an individual with a large rollover IRA, however, it is entirely possible that the amount in an IRA may exceed what is reasonably necessary. Moreover, if the person has several sources of retirement income (e.g., other IRAs or a company pension plan), the amount that is reasonably necessary from one particular IRA may be less than the whole account. …