Recent Court Case Underscores the Importance of Not Engaging in Prohibited Transactions
Estimated reading time: 2 minutes
A recent court case ruled that an individual’s IRA was not exempt from creditors despite the individual’s Chapter 7 bankruptcy filing. After the IRA engaged in prohibited transactions and lost its IRA status, the court determined that the IRA was no longer an IRA.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made sweeping changes to the handling of retirement plans during individual applications for bankruptcy. IRAs (both Traditional and Roth) have an exemption of $1,000,000 (indexed) from an individual’s bankruptcy estate.
Employer-sponsored plans such as 401(k) profit sharing plans, Simplified Employee Pension plans (SEP) and Savings Incentive Match Plans (SIMPLE) have unlimited exemption from creditors under a bankruptcy filing because they are employee benefit plans. However, the exemption applies only if the plans maintain their qualified status.
An IRA that engages in a prohibited transaction ceases to be an IRA as of January 1st of the year in which the transaction occurs. As a result, the IRA loses its tax-deferred status and the benefits that accompany it. According to the IRS, prohibited transactions include transactions considered self-dealing or benefiting the IRA holder or disqualified person while the asset remains in the IRA.
Examples of such transactions include:
- Borrowing money from the IRA
- Selling property to the IRA
- Using the IRA as security for a loan
- Buying property for personal use (present or future) with IRA funds
- Using the property while it’s under the retirement plan
- Performing services for the investment
Examples of disqualified persons:
- The IRA holder
- IRA holder’s spouse
- Family members (i.e., lineal ascendants and descendants)
- Entities that are owned at least 50% by disqualified persons
In the aforementioned court case, the IRA holder filed for bankruptcy and claimed the federal bankruptcy exemption for their Self-Directed IRA.
Due to several transactions uncovered during the bankruptcy proceedings, which included the account holder borrowing money from the IRA, and check swapping transactions involving the IRA, the court determined that the IRA engaged in prohibited transactions. As a result, the court treated the IRA as it would another any other non-IRA with regard to bankruptcy.
Because an IRA ceases to be an IRA as of January 1st of the year in which the prohibited transaction occurred, the IRA cannot avail of the $1,000,000 (indexed) federal bankruptcy exemption.
It’s very important to understand prohibited transactions to avoid losing the tax-deferred status of an IRA. Loss of the IRA’s status results in the loss of additional benefits including sheltering amounts under the federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
Visit our Learning Center to learn more about prohibited transactions.