Courts Muddy the Waters on 401(k)s in Bankruptcy

September 30, 2021

What You Need to Know

  • Inherited 401(k)s may receive creditor protection in bankruptcy if the funds remain in the inherited account when the bankruptcy petition is filed.
  • But the Supreme Court unanimously ruled that inherited IRAs were not “retirement funds” and thus were not entitled to bankruptcy protection.
  • An appeals court found that debtors cannot shield assets from bankruptcy by starting contributions after filing for bankruptcy.

Typically, creditors are not able to access a client’s traditional 401(k) or IRA in bankruptcy. As most clients know, however, different rules apply to different types of retirement accounts — and an entirely new set of rules applies to inherited retirement accounts.

Years ago, the Supreme Court held that inherited IRAs were not afforded the same bankruptcy protection as traditional IRAs because inherited accounts were not accumulated for the debtor’s retirement savings. But recent court cases have muddied the waters somewhat when it comes to determining the level of creditor protection that an inherited retirement account might receive in bankruptcy — and it’s critical that clients with creditor protection concerns understand the nuanced differences that may apply going forward.

Creditor Protection and Inherited 401(k)s

The U.S. Bankruptcy Court for the Western District of North Carolina recently held that inherited 401(k)s may also receive creditor protection in bankruptcy if the funds remain in the inherited account when the bankruptcy petition is filed. 

A key factor in the case was that the funds remained in the inherited 401(k), which was set up by the financial institution in the debtor’s name (in other words, the results would have been different if the beneficiary would have removed the inherited funds from the account by taking a distribution or rolling the funds into an IRA).

The court found that the goal of the Employee Retirement Income Security Act was to protect both retirement plan participants and their beneficiaries, so it was important that the funds remained in the ERISA-protected account. 

The court specifically distinguished this treatment for ERISA-covered plans from the treatment of inherited IRAs, which may not be protected in bankruptcy. In Clark v. Rameker, the Supreme Court unanimously ruled that inherited IRAs were not “retirement funds” and thus were not entitled to bankruptcy protection. 

This particular case, however, was decided by a lower district court and is apparently a case of first impression. The case also involved an ERISA-covered plan, meaning that clients who contribute to non-ERISA plans may not also receive the same protections. Therefore, clients should proceed cautiously and examine state laws when determining whether inherited 401(k)s can be excluded from a bankruptcy estate.