Retirement Funds From Divorce Settlement Not Safe In Bankruptcy

bankruptcy proceedings

Recently, the Eighth Circuit Bankruptcy Appellate Panel issued an important opinion that affects every person who received a share of his or her former spouse’s retirement funds in a divorce.

Typically, an IRA or a 401(k) receives near blanket protection in bankruptcy proceedings, meaning that if a person files for bankruptcy, creditors may not access those funds.

The Eighth Circuit put a significant limitation on that protection.

In Lerbakken v. Sieloff and Associates, P.A., Brian Lerbakken received in his divorce one-half the value in his ex-wife’s 401(k) and her entire IRA. Several years later, Lerbakken filed a voluntary Chapter 7 petition for bankruptcy. He listed as exempt accounts the two retirement funds he received from the divorce. The bankruptcy court disallowed the exemption, and he appealed.

The Eighth Circuit began with the premise that the exemption extends only to retirement funds. Because the Bankruptcy Code does not define “retirement funds,” the Court applied the ordinary meaning, which the Supreme Court in an earlier case stated means sums of money an individual puts in a fund he created and contributed sums to over a period of time. Monies someone receives as a gift or a settlement that was located in an IRA or 401(k) will not qualify, even if rolled over into a retirement account, because the individual debtor did not actually make the contributions. Because Lerbakken did not make the contributions but received them as part of a property settlement, they were not earned and therefore not properly considered retirement funds.

The Lerbakken decision has a wide-ranging application, as it opens up a spouse who may have only one principal asset from a divorce – the retirement funds – no longer exempt in a bankruptcy proceeding. Further, it leaves open the question of what sums in a retirement fund may be exempt – will employer contributions, since not made by the debtor himself, no longer be considered exempt?

Going forward, parties to a divorce worried about potential bankruptcy should consider other options. First, do not mix the settlement funds with your own retirement funds. Second, consider establishing an irrevocable trust to hold the settlement funds, which could at least shield the assets (but not monthly distributions) from creditors.

If you have questions about retirement funds and divorce, contact us – we can help.