Judge Edward Prado, of the U.S. Court of Appeals for the 5th Circuit. Courtesy photo

In an important personal bankruptcy decision, the U.S. Court of Appeals for the Fifth Circuit has ruled that once a Chapter 7 debtor claims an exemption for their individual retirement account, a trustee is not allowed to claim that money — even if the debtor cashes out their IRA during the bankruptcy.

The Fifth Circuit’s recent decision in Hawk v. Engelhart is the appellate court’s second try at an issue of first impression: whether a debtor who withdraws funds from their IRA and doesn’t deposit the funds into another retirement account within 60 days loses the exemption pursuant to Texas law.

The case involves Gregory and Marcie Hawk, who filed a voluntary Chapter 7 bankruptcy in 2013. The Hawks claimed that their IRA funds were exempt under the Texas Property Code and were excluded from the estate. No party objected to the Hawks’ IRA exemption.

However, a year later, one of the creditors in the case timely objected to Hawk’s discharge. And during the pendency of the bankruptcy, the Hawks withdrew all of the funds from the IRA and used most of them to pay for living and other expenses and never deposited the funds into another retirement account.

When the creditor deposed Gregory Hawk in 2014, he stated that approximately $30,000 of the liquidated funds were in his possession and were “in a shoebox.” Bankruptcy trustee Eva S. Engelhart learned about the liquidated funds from Hawk’s deposition and subsequently demanded the Hawks give the funds to the estate.

Engelhart filed a motion with bankruptcy court seeking to compel the Hawks to turn over the funds. And following an evidentiary hearing, the bankruptcy court ordered the Hawks to turn over $133,434.64 — the total amount of funds they withdrew from the IRA.

The bankruptcy court concluded that funds lost their exempt status under Texas law because the Hawks did not roll them over into another IRA within 60 days. The Hawks appealed the decision to a U.S. District Court, which affirmed the bankruptcy court’s decision, and later to the Fifth Circuit, which also affirmed the ruling in July.

The Hawks later filed a petition for rehearing in the case. And a group of amici including former Austin U.S. Bankruptcy Judge Leif Clark, University of Kentucky bankruptcy law professor Christopher Bradley, and two Texas bankruptcy attorneys also urged the Fifth Circuit to reconsider its decision and its precedent that allows trustees to claim exempted property in some cases.

The amici feared if the decision were allowed to stand, it would affect every personal bankruptcy filed in Texas — 12,500 of them last year alone — by injecting uncertainty in whether a Chapter 7 debtor’s protected retirement assets could be claimed by trustees.

In its Sept. 5 decision, the Fifth Circuit withdrew its prior decision allowing the trustee to claim the IRA money. And in doing so, the court re-examined whether its 2014 ruling in In Re Frost, which allowed a trustee to claim the proceeds from the sale of a Chapter 13 debtors exempted homestead which was sold during bankruptcy, could be applied to the Hawk’s Chapter 7 case.

“The Hawks contend that Frost does not apply to their Chapter 7 case because Frost was not a Chapter 13 proceeding,” wrote Judge Ed Prado. “The Hawks’ reason that an unconditionally exempted property interest that is subsequently transformed into a new nonexempt property interest remains excluded from a Chapter 7 bankruptcy case. We agree.”

The ruling reversed the bankruptcy court’s order requiring the Hawks to turn over the liquidated funds to the trustee and remanded the case back for further proceedings.

William Haddock, a Houston attorney who represents the Hawks, and Aaron Power, a Houston attorney who represents the bankruptcy trustee, did not immediately return calls for comment.

The ruling came as a huge relief to Stephen Sather, an Austin bankruptcy attorney who helped write the amici brief urging the Fifth Circuit to change its mind the case. Had it been allowed to stand, the decision would have would have meant debtors could not do anything with their exempt IRA accounts during the pendency of a Chapter 7 bankruptcy.

Having a group of amici point out the potential impact of the ruling likely helped in prompting the Fifth Circuit to reconsider the issue, Sather said.

“There were people other than the parties to the case that cared about it. And you know, I think sometimes judges talk,” Sather said. “And this is totally speculation, but you’ve got some Fifth Circuit judges who are very knowledgeable about bankruptcy law. And it’s not implausible that one of them said, ‘Hey guys, you need to fix this.’”