New Bankruptcy Law Affects Benefit Plans

On April 20th, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 into law. This new law contains several provisions that affect employee benefit plans.

Most plan loans are no longer dischargeable in bankruptcy. Administrators of 401(k) and other plans that make participant loans have become accustomed to receiving orders from bankruptcy trustees to discontinue withholding plan loan repayments from the paychecks of participants who have filed bankruptcy. Such orders had the effect of putting plan loans into default and producing deemed distributions. This meant that the amount of the unpaid loan plus accrued interest became taxable to the participant/debtor, generally in the year that the repayments were discontinued. Bankruptcy courts would often attempt to discharge the entire loan in the bankruptcy proceeding, causing conflicts with the provisions of the Internal Revenue Code that prohibit in-service distributions from 401(k) and certain other retirement plans.

The new law provides that the automatic stay does not apply to participant loan repayments. In addition, most plan loans are no longer dischargeable in bankruptcy. (There is a possible exception for participants who are in Chapter 13 bankruptcy and who have completed all bankruptcy plan obligations. However, a Chapter 13 plan may not "materially alter" the terms of a plan loan, and any amounts required to repay a 401(k) or other type of plan loan do not constitute disposable income which would otherwise be required to be paid to creditors under the Chapter 13 plan.) This means that plan administrators should generally be able to administer loans for participants who have filed bankruptcy the same as they do for all other plan participants.

Greater protection for retirement savings. When an individual files for bankruptcy, certain assets are exempt from the bankruptcy "estate," which contains the assets available to creditors. Before the new law, qualified retirement plans subject to ERISA were generally excluded from the estate. In addition, the U.S. Supreme Court's recent decision in Rousey v. Jacoway made IRAs exempt under certain circumstances. However, certain other retirement assets that are not subject to ERISA, such as Keogh plans that cover only owners, were not automatically exempt. In many cases, the treatment of retirement assets in bankruptcy depended on the law of the state where the debtor resided, and on whether the debtor elected to use state or federal exemptions.

The new law exempts from an individual's bankruptcy estate all retirement assets held in the following types of plans: all qualified retirement plans, 403(b) tax-sheltered annuities and custodial accounts, IRAs, Roth IRAs, government and church retirement plans, and 457 deferred compensation plans of tax-exempt organizations and state and local governments. The exemption for all types of IRAs is limited to $1,000,000 (indexed for inflation), but this limit does not apply to assets held in an IRA that were rolled over from eligible retirement plans. In addition, the exemption limit on IRAs can be increased by the bankruptcy court in the interest of justice. These changes might result in some qualified plan participants being more willing to roll their plan benefits over to IRAs. Note, however, that the new federal law does not affect claims that creditors might be able to assert against IRAs in situations short of bankruptcy, which would be governed by the relevant state laws regarding garnishment, attachment, etc.

Other provisions of the new bankruptcy law. The new law contains several other provisions that may be of interest to some employee benefit plans:

• Education IRAs and 529 savings plans are excluded from the bankruptcy estate in certain circumstances.
  
• Contributions to certain retirement plans that have been withheld from employee pay but not yet deposited with the plan when the employer files for bankruptcy are excluded from the employer's bankruptcy estate.
  
• The Act imposes strict limits on the severance and retention payments that can be made to executives and certain other employees, and to consultants, by an employer in bankruptcy.
  
• "Abandoned" retirement plans, which can result from employer bankruptcies, are minimized under a provision requiring the employer/debtor or the bankruptcy trustee to continue administering the bankrupt employer's plans.
  
• The priority in bankruptcy for unpaid employee wages and benefit contributions will increase from $4,000 to $10,000 per employee, and will include amounts earned during the 180 days before the employer's bankruptcy filing.
  
• Bankruptcy courts can set aside modifications to retiree welfare benefits if the modification was made within 180 days before the bankruptcy petition and the debtor was insolvent at the time of the modification.
  
  Effective date. The above provisions of the new law will become effective on October 17, 2005. Bankruptcies filed before that date will be subject to existing law.