Is My IRA Protected in Bankruptcy?

IRA, individual retirement accounts, are they protected in bankruptcy? I am willing to bet you expected the answer to be yes, individual retirement accounts are protected in bankruptcy. Most bankruptcy lawyers would automatically say yes, IRA accounts are protected in bankruptcy. It is common knowledge that IRA accounts are protected in bankruptcy. Do an internet search for–is an IRA protected in bankruptcy– you will see for yourself.
The correct answer is “I don’t know.”
How can that be?
Even the bankruptcy code says that IRA accounts are protected in bankruptcy. Most lawyers would automatically point to Section 522 of the bankruptcy code and argue it is right there in black and white.
However, the bankruptcy code really says that IRA accounts are protected “…to the extent that those funds are in a fund or account that is exempt from taxation…” Although this statute lists Internal Revenue Code Section 408, which governs IRA accounts, as eligible, the account must still be exempt from taxation.
Is Your IRA Tax Exempt?
That exemption from taxation can be lost when the account is not setup properly or managed properly.
The Internal Revenue Code has rules that restrict what can be done with a retirement account. These rules apply to individual retirement accounts. They are called “prohibited transactions.” Examples of prohibited transactions are in the IRS’s Publication 590.
Prohibited transactions include:

• Using the money to benefit a “disqualified person”;

• Selling, leasing, or exchanging the property in the account with a disqualied person;

• Lending money or extending credit from the IRA to a disqualified person.

A disqualified person is you, your family, your business and your employees. The basic rule is you are prohibited from receiving any benefit from the money in your IRA, unless it is authorized by the plan and governing law, for the account to stay tax exempt.
Most of these problems are easy to avoid because the custodian of the account will not let them happen. Serious problems can come up is when an independent custodian is not in the picture. There are two common situations where these prohibited transactions come up.
Real Estate Individual Retirement Accounts (IRA)
The rules against “prohibited transactions” do not allow you to sell a house you own to the IRA. You may not lend money to the IRA to purchase property. The IRA cannot be collateral for a loan used to purchase real estate. You cannot provide services to the IRA. This includes maintaining, repairing, or renting the property. These services cannot be provided by you, a business you control, or a family member. Although it is possible to have an IRA invest in real estate, the only safe way to do so is completely hands off. Otherwise, the IRA will lose its tax exempt status.
IRA Roll Overs
The tax code, section 408, allows you to switch your IRA account from one company to another. This can be done two ways. One is called a custodian to custodian rollover. This is extremely easy and safe. The new company will have a form for you to sign directing the old company to transfer the account.
Another way to rollover an IRA from one account to another is to withdraw the funds from the old account and then deposit them into the new account. The tax code allows us 60 days to complete the rollover. This 60 day window is often used as a tool to borrow from the IRA. This is a very risky strategy because the IRS does not allow you to use the money for any other purpose during the 60 day period.
IRS Rules Against Taxpayer
The IRS’s position is outlined in Private Letter Ruling 20054402 a case where the taxpayer requested as extension or waiver of the 60 day rule. The taxpayer withdrew money from his IRA to help with the purchase of a new home. Hurricane Frances hit and damaged the home. The permanent financing on the home was delayed. The permanent financing would replace the funds withdrawn from the IRA.
The IRS turned down the taxpayers request because using the IRA money to help purchase a home is a prohibited transaction.
The consequence of a prohibited transaction is the entire IRA is no longer tax exempt under Section 408(e)(2) of the tax code. Had the taxpayer not sought a Private Letter Ruling and just redeposited the money he would have risked losing the tax exempt status of the entire IRA account.
But, the tax code allows a partial rollover of an account. Section 408(3)(D) allows a taxpayer to take funds out of an IRA and deposit part of the money into a new IRA. The part put into the new IRA will continue to be tax exempt, provided it was not used for a prohibited transaction. The part not deposited is treated as taxable income.
The Bankruptcy Problem
The reason self-directed real estate individual retirement accounts and borrowing from an IRA work without widespread problems is the IRS is too busy to audit these accounts.
In a bankruptcy case it is different. It is not the IRS you need to worry about. It is the Bankruptcy Trustee.
If the trustee’s investigation shows you have entered into a prohibited transaction using the IRA funds or assets the trustee will object to your claim it is protected in the bankruptcy. A successful objection will mean the entire account is not protected in your bankruptcy. The 11th Circuit Court of Appeals agreed with this argument in a 2011 case. The Trustee has an incentive to investigate since he or she is paid a percentage of the property collected for creditors.
What to Do
If you are considering filing bankruptcy and have significant savings in an individual retirement account make sure that you meet with a lawyer that knows and understands the tax code and its rules on IRA accounts. The simple answer that IRA accounts are protected in bankruptcy is often wrong. A Chapter 7 filing is risky when you own a large IRA unless you are confident that you have not engaged in a prohibit transaction. A Chapter 13 case may be a better idea to  minimize the risk of losing the IRA account.
 
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