THE New Uniform Trust Code, RETIREMENT ACCOUNTS, AND 529 PLANS
Posted by admin on: 2007-11-20 17:23:07
THE
New Uniform Trust Code, RETIREMENT ACCOUNTS, AND 529 PLANS
Jonathan
A. Levy
Cavanaugh Levy LLP
Portland, Oregon
November 20, 2007
© 2007 by Jonathan A.
Levy. All rights reserved.
This outline covers the uses and limits of trusts,
retirement accounts and 529 plans to shield assets from creditors in Oregon.
The outline does not deal with the potential attacks
on these techniques as fraudulent conveyances or (with a few exceptions)
whether the techniques can be set aside in bankruptcy. Nor does it cover “offshore” and “onshore”
asset protection trusts in other jurisdictions or LLCs and other entities as
asset-protection devices.
I. OREGON’S
NEW UNIFORM TRUST CODE
The legislature enacted the Uniform
Trust Code (the “OUTC”) as part of Chapter 348 of the 2005 Oregon Laws. Article 5 of the UTC, now codified at ORS
130.300 – 130.325, deals with creditor claims against trust assets. The OUTC is consistent with many aspects of
prior law in the area, but it does make some important changes. These materials
highlight both the changes and the legal rules that have been preserved.
1. as with any summuary of legal rules, this outline can provide only general information based on rules in effect at the time of writing . It can not substitute for a lawyers own advice based on a client's particular circumstances. Also, although I have done my best to avoid mistakes, some might remain.
Part 1 of this outline is taken largely from the author's article, Creditor Claims and the Oregon Uniform Trust Code OR EST PLAN & Admin section newsletter, July 2006 at 7.1. I want to thank My partner Jim Cavanaugh who has provided many helpful ideas while collberating with me on the chapter "Creditor Rights and Spendthrift Clauses" in Administer Trust in Oregon
a. Rights
of Creditors When There is No Spendthrift Provision
The basic
rule involves a simple beneficiary who is neither trustee nor grantor, who is
not protected by a spendthrift provision, and who does not owe money to
special, favored classes of creditors. The rule is that creditor may reach the beneficiary’s interest in trust
distributions by garnishment or other execution against present or future
distributions to or for the benefit of the beneficiary. ORS 130.300. However,
“[t]he court may limit the award to such relief [to the creditor] as is
appropriate under the circumstances.” Id. This
limitation applies because proceedings to satisfy creditors’ claims are
equitable in nature. The drafters’
comments to the section explain that “the court may appropriately consider the
support needs of a beneficiary and the beneficiary’s family.” “The Oregon Uniform Trust Code and Comments,”
42 Willamette L Rev 187, 284, cmt to
ORS 130.300 (2006) (“Code and Comments”). The basic rule of ORS 130.300 is
consistent with prior law. See Restatement
(Second) of Trusts § 147 (1959); Restatement
(Third) of Trusts § 56 (2003).
The authorization of garnishment
simplifies the procedure for creditors. Under prior law, judgment creditors against beneficiaries could not
garnish the beneficiaries’ trust interests, because ORS 18.618(1)(a) prohibited
garnishment of equitable interests. Creditors instead had to resort to the
equitable remedy of a creditor’s bill. Creditor bills should no longer be
necessary to reach beneficiaries’ interests in Oregon. Section 98a of Chapter 248 of the 2005 Or
Laws amends ORS 18.618 to permit garnishment of equitable interests to the
extent permitted by the OUTC. Also,
section 39 of Chapter 348 specifically authorizes creditors to use “garnishment
or other execution against present or future distributions.”
The UTC does not supersede state exemption statutes.
UTC Article 5, general comment, 7C ULA 174 (2003). Thus, if an interest in property would be
exempt from creditors under non-trust law, then a beneficiary’s interest in a
trust consisting of the exempt property should also be protected. Restatement
(Second) of Trusts § 149 (1959); Restatement
(Third) of Trusts § 56,
comment d (2003). But see In re Bowers, 222 BR 191 (Bankr D Mass 1998) (bankruptcy
homestead exemption of 11 USC § 522(d)(1) did not protect debtor’s home
that was owned by his revocable trust). Exemptions provided by Oregon law are set forth in ORS
18.300 – 18.428.
B. Spendthrift Provisions
Definition of spendthrift clause. Spendthrift clauses prohibit
beneficiaries from
selling
or borrowing against their trust interests, and creditors from reaching those
trust interests against the beneficiaries’ wishes. For example, a trust might provide that a
beneficiary’s interest is “not subject to claims of creditors, nor to legal
process, and may not be voluntarily or involuntarily anticipated, alienated or encumbered.” Or a trust could simply state, “This is a
spendthrift trust.” See ORS 130.305(2); Restatement (Third) of Trusts § 58, cmt
b(3) (2003).
Validity of
spendthrift clauses. Under prior law, spendthrift
clauses of trusts established for beneficiaries by third parties were generally
valid. E.g., Shelley v. Shelley and U.S. Nat. Bank, 223 Or 328, 354 P2d
292 (1960); Stein v. U.S. National Bank,
165 Or 518, 524, 108 P2d 1016 (1941); Mattison
v. Mattison, 53 Or 254, 100 P 4
(1909). The UTC preserves this rule. ORS
130.305(1). However, a partial spendthrift clause, that permits the beneficiary
voluntarily to transfer his or her interest, is invalid. ORS 130.305(2). Also, funds from a spendthrift trust can be
reached by creditors once they are distributed, or if the trustee has retained
them after the time due for distribution. ORS 130.305(3), 130.320.
Disclaimers. A
disclaimer by the beneficiary, because it is a refusal to accept ownership of
an interest and not a transfer of an interest already owned, is not affected by
the presence or absence of a spendthrift provision. See Code and Comments at 285, cmt to ORS
130.305; see also ORS 105.629(6)
(disclaimer made under ORS 105.623- 105.649 “is not a transfer, assignment or
release”).
C. Exceptions to Spendthrift
Provisions
Under ORS
130.3100,
certain favored classes of creditors may reach a beneficiary’s interest despite
the presence of a spendthrift provision. The favored claims involve judgments for child or spousal support;
judgments in favor of providers of services to protect the beneficiary’s
interest in the trust; and certain claims of the State of Oregon
or the United States.
Spousal support and child
support. ORS 130.310(2) permits
a former spouse or a child to enforce a support order by attaching the
beneficiary’s present or future trust distributions, even if the trust contains
a spendthrift provision. Distributions subject to execution include mandatory
distributions and discretionary distributions that the trustee has otherwise decided
to make. However, the Oregon
comments to this section note that it “does not authorize the spousal or child
claimant to compel a discretionary distribution from the trust.” Code and
Comments at 287, cmt to ORS 130.310.
ORS 130.310(2) contains a limitation
not present in the uniform version of the Uniform Trust Code: the court may
issue an order reaching the beneficiary’s interest in “such amount as the court
determines to be equitable under the circumstances but not more than the amount
the trustee would have been required to distribute to or for the benefit of the
beneficiary.” For child and spousal
support, a reduction in the amount of a collection order, based on the
“equitable under the circumstances” part of this limitation, may be the exception,
not the rule. As the comment to this
section states, “Before fixing this amount, the court having jurisdiction over
the trust should consider that in setting the respective support award, the
family court has already considered the respective needs and assets of the
family.” Code & Comments at 287-88,
cmt to ORS 130.310.
Expenses to Preserve Beneficiary’s
Interest in Trust. ORS 130.310(2) permits a judgment creditor who has provided services
for the protection of the beneficiary’s interest in a spendthrift trust to
garnish the present or future distributions to or for the benefit of the
beneficiary. This exception enables a
beneficiary of modest means to obtain services to defend his or her rights in
the trust. The exception is subject to the same equitable limits that apply to
claims of spousal or child support.
Federal and
State Claims. A spendthrift provision is unenforceable against a
claim of the State of Oregon
or the United
States
to the extent an Oregon or federal statute so provides. ORS 130.310(2). This exception is consistent with the
Restatement. Restatement (Second) of Trusts
§ 157(d), comment e (1959); Restatement
(Third) of Trusts § 59, comment a (2003). It recognizes that the state and federal
government, by statute, have the power to bypass a spendthrift provision no
matter what trust law may say. The
federal tax lien is an example. However,
the OUTC does not prescribe a rule on when other statutes give supremacy to
governmental claims.
Some lawyers in Oregon and elsewhere have expressed concern that the
exception for federal and state claims will jeopardize special needs trusts for
disabled recipients of public assistance. Compare Merric & Stein, A Threat to All SNTs, Tr & Est, Nov. 2004, at 38, with Walsh, Davis, Kent & Newman, What is the Status of Creditors Under the
Uniform Trust Code?, Est Plan, Feb. 2005, at 29, 34. Under current federal law, which is binding
on states, special needs trusts funded by a third party (i.e., parent) are not
considered “available” for eligibility purposes if they leave distributions
solely to the trustee’s discretion and (in the view of more cautious
practitioners) limit distributions to the beneficiary’s supplemental needs not
covered by public assistance. Special
needs trusts funded with the recipient’s own assets are subject to stringent
rules and normally do not preserve the assets, after the recipient’s death, for
other family members. See generally
Special Needs Trusts (OSB 2003); Elder Law chs 8 & 9 (Oregon CLE 2000 & Supp 2005); Clifton Kruse, Third-Party and
Self-Created Trusts (3d ed 2002). The real concern
perhaps is that a new express exception for state or federal claims will
trigger an open season on special needs trusts. But the Congress, which holds the keys, has long had the power to change
Medicaid law. Its recent tinkering with
that law has not included a challenge to special needs trusts. The policy
reasons still apply that, in the past, persuaded the Congress to respect
constituents’ wishes, within broad limits, in leaving their life savings to
loved ones.
Other Exceptions Excluded. Commentators and courts have sometimes
suggested that other classes of creditors, such as tort victims, be permitted
to reach assets of trusts with spendthrift provisions. However, the OUTC
excludes these other exception creditors. See
ORS 130.305(3) (“[e]xcept as otherwise provided in ORS 130.300 to 130.325, a
creditor or an assignee of a beneficiary may not reach the interest of a
beneficiary or a distribution by the trustee before the distribution is
received by the beneficiary.”).
Notable among these non-listed creditors are
providers of necessary goods and services to the beneficiary. The UTC comments explain that most of these
cases involve claims by governmental entities, which are better handled by
special legislation. See Code and
Comments at 288, cmt to 130.310.
D. Discretionary Trusts, Support Trusts, and Forfeiture
Clauses
Discretionary Trusts. Section 504 of the Uniform Trust Code
generally prohibits creditors from compelling distributions from discretionary
trusts. There is an exception for
creditors who seek to enforce payment of spousal or child support. Section 504 has proved controversial. See,
e.g., Merric & Oshins, UTC May
reduce the Asset Protection of Non-Self-Settled Trusts, Est Plan, Sept. 2004, at 411. Oregon did not adopt the section,
because of disagreement among interest groups on the proper scope of
enforcement of spousal and child support against discretionary trusts. See Code and Comments at 289, cmt regarding
omitted section 504.
Without section 504, it appears that the governing
law in Oregon remains Shelley
v. Shelley, 223 Or 328, 354 P2d
292 (1960). In Shelley, the court held that the trust’s spendthrift provision was
ineffective to bar claims of the beneficiary’s children and the former spouse
against the beneficiary’s mandatory
income interest, but the court could consider various factors in making
equitable adjustments between the claimants and beneficiary. On the other hand, the court noted that the
beneficiary could not demand discretionary
distributions and, therefore, the children and former spouse could not either.
Hybrid Trusts. Some trusts call for distributions to
beneficiaries in the trustee’s discretion, but based on a standard, such as
support. The extent to which creditors
of beneficiaries can compel distributions from hybrid trusts is unclear.
Forfeiture Clauses. A trust may provide that the beneficiary’s interest
in trust income or future payments of principal will be forfeited if the
beneficiary’s creditors attempt to reach the interest. The OUTC does not address forfeiture
clauses. However, under common law, they
are generally valid, unless the beneficiary is entitled to immediate
distribution of principal, or the principal is payable to the beneficiary’s
estate after the beneficiary’s death, Restatement
(Second) of Trusts § 150, comment b; § 153, or if the grantor has
retained a beneficial interest in the trust, Restatement
(Third) of Trusts § 57, comment b (2003). It is
doubtful that the OUTC will be held to overturn the effectiveness of these
clauses. See ORS 130.025 (common law of trusts and principles of equity
supplement the OUTC, except as modified by the OUTC or other law).
E. Creditor’s Claims Against Trust Settlor
During Settlor’s Lifetime. During a settlor’s lifetime,
creditors can reach property of a revocable
trust, whether or not it contains a spendthrift provisions. ORS 130.315(1). This is consistent with prior law. Restatement
(Second) of Trusts § 156(1)(1959); Restatement
(Third) of Trusts § 58, comment b (2003). A creditor of the grantor of an irrevocable trust may reach the maximum
amount that can be distributed to, or for the benefit of, the grantor. If the trust has multiple grantors, the
amount the creditor of one can reach may not exceed that grantor’s interest in
the portion of the trust attributable to that grantor’s contribution. ORS
130.315(b).
After Settlor’s Death. If a trust was revocable at the settlor’s
death, the property of the trust, after a trust settlor’s death, “becomes
subject to creditors’ claims as provided in ORS 130.350 to 130.450 when the
settlor dies. ORS 130.315(1)(c). This is consistent with prior law. See
Johnson v. Commercial Bank, 284 Or
675, 588 P2d 1096 (1978). The payment of claims is subject to the settlor’s
right to direct the priority of the sources from which liabilities of the
settlor are to be paid.” ORS 130.315(1)(c).
ORS 130.350 to 130.450 describes the optional,
probate-like notice-and-claim procedure that the trustee may initiate. This
procedure was previously codified at ORS 128.256 to 128.300. The reference in ORS 130.315(1)(c) perhaps
might be read to limit the right of recovery against trust assets to instances
when the trustee elects to invoke the procedure. However, that was not the intent of the
section drafters. As the comments state:
“[The subsection] recognizes that a revocable trust is usually employed as a
will substitute. As such, the trust
assets, following the death of the settlor, should be subject to the settlor’s
debts and other charges as provided in ORS 128.256 to 128.300.” Code and Comments at 291, cmt to
130.315. Moreover, if ORS 130.315(1)(c)
left it up to trustees to decide whether revocable trust assets were available
to creditors, that section would be meaningless. No trustee would open up trust assets to
creditors, because that would likely violate the trustee’s fiduciary duty to
beneficiaries.
For purposes of creditors’ claims, the holder of a
power of withdrawal is treated in the same manner as the settlor of a revocable
trust, to the extent property of the trust is subject to the power. ORS 130.315(2). This, too, is consistent with prior law.
Who is a Trust Settlor? Sometimes a beneficiary is treated as a
settlor even without having contributed assets. Two common examples involve beneficiaries of Crummey trusts and tort
claimants.
With a Crummey trust, one person makes gifts of
property to a trust and gives beneficiaries a brief period to elect to withdraw
their share of the assets contributed. Because the beneficiaries have a right of withdrawal, the gifts are
present interests that qualify for the annual gift tax exclusion under IRC §
2503(b). Although there is no case law
on point, a trust beneficiary with a Crummey power could be treated as a
settlor for purposes of creditors’ claims. If so, the spendthrift provision may not protect property that was
subject to the withdrawal power. The IRS already treats a Crummey
power holder as a grantor for income tax purposes. See,
e.g., PLR 200157044.
The OUTC
reduces this potential risk. First, ORS
130.315(2) provides that the holder of a power of withdrawal is treated as the
settlor, for purposes of creditors, only while the power may be exercised. Thus, if the withdrawal power lapses after 30
days, creditors must take action during that brief period. Thereafter, or after the power is released or
waived, the trust property that is subject of the lapse, release or waiver becomes
available to creditors of the holder of the power only to the extent the value
of the property exceeds the greater of the amount specified in IRC Sections
2041(b)(2) or 2514(e), as in effect on January 1, 2006 [greater of 5% or $5,000], or IRC
Section 2503(b), as in effect on that date [$12,000]. ORS 130.315(3).
Spendthrift
trusts are often established by court decree or agreement to satisfy tort
claims originally presented by the beneficiaries. Even though the beneficiaries are not the
nominal grantors, these trusts are treated as self-settled trusts available to
creditors. E.g., In re Jordan, 914
F2d 197, 198 (9th Cir 1990); In re Stragalas, 208 BR 693, 694 (Bankr D
Ariz 1997); see Restatement (Third) of Trusts § 58,
reporter’s notes comment f (2003) (collecting cases).
Powers of
Appointment. The OUTC does not address the extent to which creditors can reach
property subject to a special power of appointment or a testamentary general
power of appointment held by a debtor. Code and Comments at 292. For a summary of creditor rights, see
Jonathan Levy and James Cavanaugh, Creditors’
Rights and Spendthrift Clauses, Administering
Trusts in Oregon, §§ 10.12 – 10.20 (OSB CLE 2007).
F. Personal Obligations of
Trustee
Non-Beneficiary Trustee. Normally, assets held by a debtor who is a trustee
for others, but not a beneficiary, are unavailable to the debtor or the
debtor’s creditors. 5 Collier on
Bankruptcy ¶541.11[5] (15th ed
2000); In re Coupon Clearing Service, Inc.,
113 F3d 1091, 1099 (9th Cir 1997). The
OUTC preserves this rule. ORS 130.325.
Beneficiary Trustee. Creditors may have more success if the
debtor-trustee is also a beneficiary. In
the view of the Third Restatement, creditors can reach assets to the extent
debtor-trustee could distribute those assets to himself or herself. Restatement
(Third) of Trusts § 60, comment g (2003). The OUTC contains a non-uniform provision
that narrows the reach of creditors. In
essence, the trust assets are protected from creditor claims to the extent the
trustee’s discretion is limited by an ascertainable standard. ORS 130.315(4). The commentary to this language explains that
the broader availability of assets to creditors under the Restatement would
“unduly disrupt standard estate planning.” See Code and Comments at 287,
cmt to 130.315.
An additional safeguard against
creditors, where a beneficiary is trustee, is to name one or more co-trustees
whose consent is required for distributions or who have sole discretion for
distributions to the trustee-beneficiary. In
re Hersloff, 147 BR 262 (Bankr MD Fla 1992); In re Schwen, 240 BR 754 (Bankr D Minn 1999). If the trustee cannot force distributions,
creditors should not be able to either.
Trustee Removal Power. There is a risk that a non-trustee
beneficiary will be treated as a trustee, or that a spendthrift provision will
be treated as illusory, if the beneficiary has the power to remove and replace
the trustee with a person under the beneficiary’s control. See In
re Baldwin, 142 BR 210 (Bank SD Ohio 1992). It is safer to permit the beneficiary only to appoint a bank, trust
company or other independent trustee.
G. Life Insurance Payable to a
Trust
Background. Life insurance on a debtor’s life that is not
payable to the purchaser’s estate cannot be reached by creditors, even in bankruptcy. ORS 743.046(1) & (3). This is also true for a policy of group life
insurance payable to a person or persons other than the insured individual’s
estate. ORS 743.047(1). One rationale is that the deceased debtor’s
dependents should have preferred status over creditors. Milwaukie
Construction Co. v. Glens Falls Insurance Co., 389 F2d 364 (9th Cir
1968).
The insured owner of the policy
may change the beneficiary when that right is expressly reserved in the
policy. ORS 743.046(5). However, when the insurance proceeds are
received by the beneficiary, they may not be exempt from the beneficiary’s
creditors. In re McAlister, 56 BR 164 (Bankr D Or 1985). Further, when the owner of the life insurance
policy assigns an interest in the policy during his or her life to creditors,
they may have priority over the named beneficiaries. E.g.,
Duty v. First State Bank of Oregon,
71 Or App 611, 617, 693 P2d 1308, rev denied, 278 Or 822 (1985).
Life Insurance Payable to a Trust. Under prior law, as noted above, assets of
a settlor’s revocable trust were available at his or her death to the settlor’s
creditors. It was therefore unclear
whether payment of life insurance proceeds to the deceased owner’s revocable trust
exposed the proceeds to the owner’s creditors. Creditors could argue that the proceeds, once in the trust, deserved no
special treatment. Trust beneficiaries
could respond that the proceeds were protected by ORS 743.046 and 743.047.
The OUTC appears to resolve this issue in favor of
the beneficiaries. ORS 130.150(2)(c)
states that “Death benefits received by the trustee are not subject to the
debts of the designator … to any greater extent than if the death benefits were
payable to the beneficiaries named in the trust and not to the estate of the
designator.” “Death benefits” include
the proceeds of life insurance policies. ORS 130.150(3)(a). The
“designator” is the person entitled to designate the beneficiary. ORS
130.150(3)(b). The statute includes
trusts created by the owner’s declaration, as well testamentary trusts and
trusts created by transfers of property to another person as trustee. ORS 130.150(1).
H. Further Reading
on Asset Protection and Trusts
For further reading, useful resources include the
comments of the National Conference of Commissioners on Uniform State Laws and
comments of the committee that drafted Oregon’s UTC. The NCCUSL comments are available in volume
7C of the Uniform Laws Annotated and at the website of the University of
Pennsylvania Law School, http://www.upenn.edu/bll/ulc/ulc.htm. The Oregon comments have
been published
in volume 42, number 2 of the Willamette Law Review, cited in these
materials. For a more detailed treatment
of creditors’ rights against trusts assets, see Jonathan Levy and James
Cavanaugh, Creditors’ Rights and
Spendthrift Clauses, Administering
Trusts in Oregon, ch 10 (OSB CLE 2007). For the impact of bankruptcy on estate
planning, see Jonathan Levy, Bankruptcy
and Estate Planning in Oregon, Or Est
Plan
& Admin Section Newsletter, Apr. 2007, at 1.
II. RETIREMENT BENEFITS
For many persons, retirement savings
are the main bulwark against poverty in old age. Federal and state laws recognize the
importance of retirement savings by protecting retirement accounts against
claims of creditors. At the same time,
federal bankruptcy and state non-bankruptcy laws also recognize the need to
make debtors’ assets available to satisfy claims of creditors. The interplay between these two principles is
the subject of this part II.
A. Non-bankruptcy Law
1. Federal protection under ERISA
(a) Description
of federal protection
Many retirement accounts, including
traditional pensions and 401(k) plans, are protected from creditors outside
bankruptcy by federal law. Section
206(d)(1) of ERISA states that each pension plan “shall provide that benefits
under the plan may not be assigned or alienated.” 29 USC § 1056(d)(1). Similarly, IRC § 401 states that “[a] trust
shall not constitute a qualified trust under this section unless the plan of
which such trust is a part provides that the benefits provided under the plan
may not be assigned or alienated.” 26 USC § 401(a)(13)(A); Treas Reg
§ 1.401(a)-13(b)(1). The
“anti-alienation” clause thus required is similar to traditional spendthrift
trusts: it keeps retirement plan assets beyond the reach of creditors.
The impact of the anti-alienation
clause can be dramatic. In Guidry v. Sheet Metal Workers Pension Fund, 493 U.S. 365
(1990), the United States Supreme Court ruled that a state court could not
reach pension assets of a union official who had embezzled funds of his
employer. In a Wisconsin case, a convicted criminal
could not be ordered to pay over ERISA retirement funds to his victims as
restitution in order to receive probation rather than jail time. State
v. Kenyon, 593 NW2d 491 (Wis App 1999).
(b) Exceptions
to federal protection
Not all retirement plans are covered
by ERISA’s anti-alienation provision. Certain retirement accounts – notably including IRAs – are not subject
to the part of ERISA that mandates the anti-alienation provision.
Also, ERISA may not protect (1) retirement plans that are not administered in
compliance with the relevant tax rules; (2) amounts that have been distributed
out of plans to the participants; and (3) participants whose debts are to the IRS, or to ex-spouses or
children for court-ordered support. See Jonathan Levy, Retirement Planning and Investing, Elder
Law § 3.28A (Supp 2005).
However,
as the next sections will explain, Oregon law and the new federal
bankruptcy fill some of these gaps.
(c) Protection
of retirement accounts under Oregon law
In Oregon,
a broad range of retirement plans are protected by ORS 18.358. Here, Oregon
is far more protective than some other states. Under ORS 18.358(1), these
exempt plans include pension plans arising under ERISA, 403 and 457 plans,
IRAs, Roth IRAs, and state and municipal pensions. As a further safeguard, ORS 18.358(2) creates
a conclusion presumption that retirement plans are valid spendthrift trusts
under Oregon law, whether or not
self-settled.
As with
federal law, Oregon law provides
a partial exception for alimony and child support. In general, 75% of a beneficiary’s interest
in a retirement plan is exempt from claims. ORS 18.358(3)(b). A related
statute, ORS 18.348, protects the proceeds of exempt assets when deposited in
an identifiable account of the debtor. This exemption is limited to an accumulation of funds of $7,500 or
less. Presumably, the debtor may spend
the proceeds on living expenses and then replenish the account from time to
time.
In
general, 75% of disposable earnings (counting both retirement income and other
earnings) is exempt from execution by creditors. ORS 18.385(1). A second, separate limit also exempts
disposable earnings if the debtor would otherwise be left with less than $170
per week of net disposable earnings. ORS
18.385(2). This partial exemption does
not apply in bankruptcy or protect against collection of federal or certain
state tax debts. ORS 18.385(5) &
(6).
(d) Possible
federal preemption of Oregon law
Although Oregon law gives broad protection
to retirement benefits, it is possible that the protection, for some types of
accounts, is preempted by federal law. Accounts affected include “top hat” plans, § 457 plans, and perhaps
tax-sheltered annuities under §403(b), Keogh plans, and SEP-IRAs. E.g., Lampkins v. Golden, 2002-1 U.S. Tax Ca. (CCH) ¶ 50,216 (6th Cir 2002)
(SEP-IRA). However, protection of
traditional IRAs – the most common non-ERISA plan -- is not preempted. This issue is discussed in more detail in
Jonathan Levy, Retirement Planning and
Investing, Elder Law § 3.28C
(Supp 2005).
B. Federal bankruptcy law
Bankruptcy law can alter the state
law protection of a debtor’s assets. Bankruptcy is the ultimate test of debtors’ and creditors’ rights. A creditor can normally force a person into
bankruptcy to collect unpaid debts. In a
bankruptcy proceeding, the bankruptcy trustee has extensive powers to gather
and liquidate the debtor’s assets.
1. Assets excluded under
applicable nonbankruptcy law
For retirement accounts, like other
assets, there are two possible ways for a debtor to prevent assets from going
into the bankruptcy estate. The first is
§541(c) of the Bankruptcy Code (11 USC § 541(c)). Under §541(a), nearly all of the debtor’s
property becomes part of the bankruptcy estate. However, §541(c) excludes the debtor’s interest in a trust with a
spendthrift provision enforceable under “applicable nonbankruptcy law.” 11 USC § 541(c). In the leading case in this area, Patterson v. Shumate, 504 U.S. 753
(1992), the Court decided that “applicable non-bankruptcy law” includes ERISA,
with its anti-alienation provision, as well as state law. As a result, retirement plans subject to
ERISA’s anti-alienation rules are not available to most creditors in
bankruptcy.
2. Exempt assets
A second potential shelter exists
for a debtor’s assets that are not excluded from the bankruptcy estate by
§541(c): §522 of the Bankruptcy Code permits a debtor to elect to exempt
certain property of the bankruptcy estate. For Oregon residents, the relevant
provision is §522(b)(2), which exempts from creditors’ claims property that is
exempt under state law. As noted above,
the Oregon exemption is broader than the ERISA exemption.
3. The Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005
The Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 significantly expands the federal protection of
retirement accounts in bankruptcy. It
amends §522 of the Bankruptcy Code to create a new general rule that most
retirement accounts are exempt assets, even in states, like Oregon, that have
chosen their own exemptions. The new rule applies to pension funds exempt under
IRC §§ 401, 403, 408, 408A, 414, 457, or 501(a). 11 USC §§
522(d)(12) & 522(b)(3)(C).
There is a $1 million cap to this exemption for
IRAs and Roth IRAs. However, it does not
apply to IRAs in SEPs, in SIMPLE accounts, or that are rollover contributions
from other types of retirement accounts. 11 USC
§ 522(n).
The 2005 Act also clarifies the exemption for
retirement plans that may not be in full tax compliance. Funds are exempt if (1) the plan has received
a favorable IRS determination letter and the
determination is in effect as of the date of the bankruptcy filing; or (2) if
there is no favorable determination letter, but either the plan is in
substantial compliance with tax rules or the debtor is not materially
responsible for the plan’s noncompliance. 11 USC §§ 522(b)(4)(A) & (B).
III. 529 ACCOUNTS
A. Introduction to 529 Plans
Section 529 of the Internal
Revenue Code authorizes the states to set up tax-exempt retirement accounts for
college savings. Oregon,
like other states, has established such a plan. See
http://www.oregoncollegesavings.com;
ORS 348.841 – 348.873. Earnings with a contributor’s account are free of both Oregon and federal income taxes. Withdrawals for qualified education expenses, such as tuition, books and
room and board, are also not taxed. Withdrawals for other purposes are taxed at
ordinary income tax rates, plus an additional 10% federal tax.
B. Oregon’s 529 Plan as an
Asset-Protection Vehicle
Section
529 plans have been widely publicized as a way to saving for children’s higher
education. What is less well known is
that they are useful for asset protection. At least for Oregon residents who set up these accounts, the account balances
and the right of withdrawal are exempt from claims of creditors of both the
account owner and beneficiaries. ORS
348.863(2). In addition, funds, once
withdrawn, remain exempt as long as they are deposited in an identifiable
account of the debtor that does not exceed $7,500. ORS 18.348(1) Presumably, the
debtor-owner or debtor-beneficiary can spend the proceeds (such as for a
tuition installment) and then replenish the account from time to time as
needed.
The
usefulness of 529 plans for asset protection is magnified by their large
contribution limits. Oregon’s
plan permits owners to invest up to $250,000 for future higher education
expenses per beneficiary over the life of the plan. Moreover, owners can contribute up to $55,000
per beneficiary in a single year, or $110,000 per couple, to take advantage of
five years’ worth of annual gift exclusions at once, in advance. IRC § 529(c)(2).
C. Protection
for 529 Plans Under the New Bankruptcy Law
The Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 recently clarified the federal protection of section 529
plans in bankruptcy. See 11 USC
§§ 541(b)(5) & (6). Qualified
contributions to these plans are excluded from the bankruptcy estate if certain
conditions are met. The designated
beneficiary must be a child, stepchild, grandchild or step-grandchild of the
debtor for the tax year in which the funds were placed in the account. The contributions must be made at least 365
days before the date of the debtor’s bankruptcy petition. If the contributions were made at least 365
days pre-petition, but less than 720 days pre-petition, the exclusion is capped
at $5,000. If the
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