Did the U.S. Supreme Court Really Protect IRAs from Creditors?

You may have recently read in the WSJ that on April 4, 2005, the United States Supreme Court issued its opinion in Rousey v. Jacoway, which unanimously held that individual retirement accounts (IRAs) are exempt from creditors' claims under the federal bankruptcy laws. Did this Supreme Court decision make new law, or is it business as usual? Well, let's take a closer look and see what the "old wise men and women" ruled.

Bankruptcy Exemptions and the Rousey Decision

Bankruptcy is a two-way street. When a debtor files for bankruptcy, many (if not all) of his outstanding debts are discharged, but in return for this protection the debtor must give up many of his assets to repay (if at least partially) those debts. However, the debtor isn't expected to give up all of his assets. Federal law "exempts" certain assets from creditors' claims in a bankruptcy, including pensions and profit-sharing plans. Lower federal courts have split on the issue of whether IRAs are "similar" to pensions and therefore exempted from creditors' claims under federal bankruptcy laws. In Rousey, the U.S. Supreme Court decided this issue once and for all and held that IRAs-just like pensions and profit-sharing plans-are protected in bankruptcy proceedings.

First and foremost, it is important to understand that Rousey is a bankruptcy case. If a debtor is not in bankruptcy, then state laws dictate whether IRAs are exempt. Some states like Florida and Texas will exempt from creditors 100% of the value of the IRA. Other states, such as California, have a limited state exemption, generally for the reasonable necessaries of the debtor and his dependents.

Of course, filing for bankruptcy is a decision that should always be made with due deliberation since the consequences of such decision will be far reaching. Whether or not a debtor's IRA will be protected may be one factor, but should not be the only factor, in determining whether filing for bankruptcy is appropriate.

Assuming that a debtor decides to file bankruptcy, the protection afforded IRAs by the federal bankruptcy laws may not be absolute. Moreover, the impact of the Rousey decision will vary from state to state, depending on each state's laws. Finally, it is not at all clear whether Rousey applies to Roth IRAs.

Limitations on the Creditor Protection of IRAs

For a number of reasons, despite the WSJ's reporting of the Supreme Court's decision in Rousey, there is no absolute protection for IRAs from one's creditors.

The federal bankruptcy exemption of IRAs is limited. The Bankruptcy Code provides that pension plans and the like, which now includes IRAs, are exempt from a debtor's bankruptcy estate "to the extent reasonably necessary for the support of the debtor and any dependent of the debtor." This language was not at issue in the Rousey case, but lower courts have generally interpreted "support" in this context as subsistence or close to it. Thus, if the debtor has other means of support, such as wages, it is possible that the debtor's IRA will not be exempt from his creditors. Likewise, if the debtor has a multi-million dollar IRA, even if the IRA is the debtor's only source of income, federal bankruptcy laws will protect only so much of the IRA as is necessary for the debtor's support.

State laws may dictate whether federal bankruptcy exemptions are applicable. Federal bankruptcy laws permit each state to decide which set of bankruptcy exemptions are available to a debtor residing in that state. Generally, a bankruptcy debtor may be able choose between a federal or state list of assets exempted from creditors (but not both) or may be required to use one list over the other. Clearly, for bankruptcy debtors using state law exemptions (either by choice or as required), the Rousey decision is of little consequence since such debtors' IRAs will be protected from creditors (if at all) based on state law exemptions.

Roth IRAs may not be protected under Rousey. At issue in Rousey were "traditional" IRAs (including traditional rollover IRAs). In finding these types of IRAs to be "similar" to other exempted retirement plans, the Supreme Court relied heavily on certain features of traditional IRAs that do not exist for Roth IRAs. Thus, it is not clear at all that Roth IRAs will be exempt under the rationale of Rousey. One should therefore proceed with caution before automatically assuming that all types of IRAs are protected under Rousey.

Therefore, don't believe everything you read, especially when it come to some "pinhead" financial reporter attempting to explain complex legal decisions that are important and can influence how you structure your financial and legal affairs. As you can see, whether a debtor's IRA is protected from his creditors depends on a myriad of factors-including whether the debtor has filed bankruptcy, the debtor's state of residence, and the debtor's means of support.