Over the past several years, courts across the country have chipped away at protections for retirement assets against creditors. The protections that were previously taken for granted are now at risk. Family law practitioners should be especially cautious when advising clients on how to divide retirement assets upon divorce as recent decisions may render previously protected assets vulnerable to creditors. For most families, retirement assets are their largest or second largest asset after the family home. Consequently, attorneys must be aware of the changing case law on retirement funds and, accordingly, advise clients on how to protect their assets.
Retirement funds, such as an individual retirement account (IRA) or 401(k), are generally protected from creditors in and out of a bankruptcy proceeding. The Bankruptcy Code has been interpreted to provide that the court must balance the needs of the creditors against those of the debtor. Typically, assets included in the debtor’s estate are available to creditors and, when assets are carved out of the estate, this naturally limits the ability for creditors to be paid. Exemptions provided by the Code are essential to protecting the debtor’s needs—including the ability to, one day, retire. Because of this balance of the debtor’s and creditors’ needs, there are some known exceptions to the protections of retirement assets. For example, a traditional IRA funded by an individual (as opposed to a 401(k)) is only protected up to an inflation-adjusted cap which is currently just under $1.3 million. Another known exception to the protection of a retirement asset is for the payment of child support or alimony.
This article will review three decisions, one unreported case from New Jersey, one United States Supreme Court case, and a recent case out of the Eighth Circuit Bankruptcy Appellate Panel. We will discuss how these decisions are shaping the legal landscape for the equitable distribution of retirement assets and rights of debtors and creditors, and how this may provide some future guidance for clients and attorneys.
In 2012, the New Jersey Appellate Court affirmed the trial court’s decision to award a constructive trust over the husband’s IRA to pay the ex-wife’s counsel fees. Gottbetter v. Gottbetter, No. A-4800-10T3, 2012 WL 2285170 (N.J. Super. Ct. App. Div. June 19, 2012). In Gottbetter, the ex-husband was ordered to pay the ex-wife alimony. Shortly after the divorce, the ex-husband filed a motion to modify alimony and claimed that his income had significantly decreased. It became apparent through expert reports that the ex-husband’s claims were not true, and the ex-husband withdrew his motion on the eve of the plenary hearing. The ex-wife then requested an award of professional fees in the amount of $125,528, and the trial court granted the order. The trial court also imposed a constructive trust over the ex-husband’s IRA to pay the fee award. The decision was supported by prior reported cases which found that attorney fee awards are not dischargeable in bankruptcy because they are akin to spousal support. As such, the fees could be paid from the otherwise protected IRA under the same exception.
Two years after Gottbetter, the United States Supreme Court determined that an inherited IRA was not exempt from creditors in a bankruptcy action. Clark v. Rameker, 573 U.S. 122, 133 (2014). The court found that an inherited IRA (in this instance inherited by the daughter of the decedent) did not constitute “retirement funds” under the bankruptcy code. The inherited IRA was not a retirement fund because the daughter could not contribute additional money into the account, was required to withdraw money from the account even if she had not reached retirement age, and had the ability to withdraw the entire balance of the account at any time without penalty. While a traditional IRA incentivizes an individual to save money and not withdraw funds early, an inherited IRA could be used like a checking account, albeit, one with income tax consequences. The court reasoned that it would be unfair for the inherited IRA to be exempt from creditors when the debtor could use “the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.” Id. at 129. These characteristics of an inherited IRA distinguish it from a traditional IRA and, therefore, in this case, justified including the asset in the bankruptcy estate. Although the Clark decision does not directly affect divorce cases, the analysis became important in subsequent decisions.
In October 2018, the United States Bankruptcy Appellate Panel for the Eighth Circuit determined that a 401(k) and an IRA that were received as part of a divorce did not constitute retirement funds and were therefore not exempt from creditors. In re Lerbakken, 590 B.R. 895 (B.A.P. 8th Cir. 2018). Brian Lerbakken was awarded half of the value of his ex-wife’s 401(k) and the entire value of her IRA as part of their divorce settlement. Subsequently, Lerbakken filed for Chapter 7 bankruptcy. In the bankruptcy petition, Lerbakken argued that the retirement accounts were exempt. Lerbakken’s counsel from his divorce were owed money and sought to be paid from the retirement accounts. The court determined that the attorneys could be paid from the retirement assets Lerbakken received in the divorce.
The Lerbakken decision relied on Clark and found that the retirement assets the husband received upon the divorce resulted solely from a property settlement agreement, and that he did not “create and contribute the funds into the retirement account.” Lerbakken, 590 B.R. at 897. Interestingly, the court in Lerbakken did not consider the same analysis as Clark. In Clark, the Supreme Court considered whether or not the inherited IRA held the same characteristics of a traditional IRA and therefore whether or not the account can constitute a retirement fund. In Lerbakken the court only considered who created and contributed funds to the account. This logic runs contrary to the equitable nature of family court which would not place weight on whether one spouse or the other used their income to fund the retirement account. In family court, how an asset is titled holds little weight because the court is focused on whether the asset was acquired during the marriage. This rationale supports family structures where one person may be the primary breadwinner but the other spouse supports the family through non-financial means such as caring for the children.
The evolution from Gottbetter to Lerbakken is extreme from the viewpoint of the spouse receiving the retirement funds that they otherwise believe are free from creditors. While Gottbetter aligns with society’s desire to ensure financial support for spouses and children, Clark and Lerbakken favored the needs of the creditor over those of the debtor. Clark and Lerbakken also made an entire asset subject to attack from creditors as opposed to the Gottbetter decision, which merely interpreted the extent to which an exception for a particular debt (in that case whether counsel fees were akin to spousal support) applied. All three decisions show a court’s willingness to use retirement assets to pay debts.
The Lerbakken decision is not controlling law across the United States, but practitioners should proceed with caution. Lower courts in other circuits differ on how to treat retirement assets awarded to a debtor in a divorce. The inconsistent treatment of the assets means all professionals should carefully consider how they advise clients and handle IRA assets that are acquired during a divorce. The use of a Qualified Domestic Relations Order (QDRO) would not have changed the Lerbakken outcome, and the case makes no distinction.
One remedy would be to avoid the Lerbakken outcome by advising clients to retain their individual retirement assets upon divorce and to use other assets to reconcile any discrepancy in values taking into consideration future tax obligations when the retirement is accessed in the future. For example, if the wife has $100,000 in an IRA and the husband has $75,000 in a 401(k), upon divorce they should each retain their accounts and reconcile the $25,000 difference out of a different asset with some adjustment if necessary for tax disparity. For many families, this resolution will not be possible. The parties may have retirement assets in one spouse’s name alone or there may not be enough liquid assets to reconcile the discrepancy. In those cases, other solutions such as the use of a trust may provide the needed protection from creditors while affording the desired financial outcome for the parties. Clients should be cautioned against rolling a retirement account received in a divorce into their individual accounts which could place the individual account at risk from creditors. Under any scenario, parties must be advised of the risks and given the opportunity to decide how to proceed. This may require the retention of external professionals or firms with multiple practice areas to handle the wealth management aspect of the divorce.
In closing, all professionals must keep current and review cases like Gottbetter, Clark and Lerbakken to stay in touch with developing case law regarding how particular assets held by clients are treated post judgment, to ensure that a client receives distribution of property as initially intended. The evolving law in different practice areas, such as bankruptcy and tax, can have significant ramifications in the family law arena. It is imperative that clients be advised properly, given the significant financial stakes present in matrimonial disputes.
Carl J. Soranno is a member and chair of the Family Law Practice at Brach Eichler, in Roseland. Mia V. Stollen is an associate of the firm. Eric L. Abramson is a wealth management professional, who is associated with Certified Financial Services in Paramus.