Advanced Underwriting Consultants

Ask the Experts – July 14, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: If my client is going through bankruptcy and receives a life insurance death benefit from on his father’s life during the proceeding, will the death benefits be protected from creditors?

Answer: It depends on the state. In bankruptcy, the debtor is able to exclude certain assets from his bankruptcy estate (referred to as exemptions). While the bankruptcy code sets forth the federal bankruptcy exemptions, Congress has given the states the choice to create their own exemptions that the state can either require residents to use, or allow residents to use (with the option to instead choose the federal exemptions).

Currently, every state has created its own set of asset protection laws, and 19 states and the District of Columbia have given their residents a choice between the state exemptions and the federal exemptions.

The federal government doesn’t protect the death benefits a debtor receives as a beneficiary unless the debtor is a dependent of the insured, and then they are protected only to the extent necessary for support of the debtor.

For example, consider the recent bankruptcy case In re Sizemore (12/5/13), where a debtor going through bankruptcy received $100,000 from her ex-husband’s life insurance policy. Being a resident of Kentucky, the debtor had the choice of using either federal or state exemptions. The debtor sought to exempt the entire amount under the federal bankruptcy protections, but the bankruptcy court held that life insurance proceeds were part of the bankruptcy estate. Therefore, the life insurance proceeds could not be excluded from the debtor’s bankruptcy estate.

Also consider In re White (5/16/14), a bankruptcy case using Alabama state exemptions. Under Alabama’s bankruptcy exemption laws, death benefits of a life insurance policy are exempted from the estate if the beneficiary is the person who effected the policy in the first place.

In White, a married couple were going through divorce. The wife, who was the insured on a $50,000 life policy, died, and her husband was the beneficiary. The husband claimed that the proceeds from the policy on his wife’s life were protected from his creditors under Alabama exemption laws. He argued that he was the one who effected the policy because (1) she obtained the life insurance through his employer, and (2) he paid the premiums.

The bankruptcy court, however, ruled that because the wife was the owner of the policy, she was the one who effected the policy. Therefore, the death benefits were not protected under Alabama’s exemption laws.

A client going through bankruptcy should check with a local bankruptcy attorney to fully understand his state’s exemption laws that may apply.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – July 9, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are inherited IRA funds exempt from creditors in bankruptcy?

Answer: It depends on the state. All states have their own bankruptcy exemption laws, but regardless of whether a state opts out of the federal bankruptcy protections, retirement funds held within a tax-qualified retirement account must be protected from creditors in bankruptcy.

At first this might seem like a pretty simple rule—for example, 401(k) accounts, governmental 457(b) plans, 403(b) tax-sheltered annuities, and IRAs (up to $1,245,475) are all excludable from the bankruptcy estate. Does this mean inherited IRAs are protected as well? After all, an inherited IRA is still an “individual retirement account.”

On June 6, the Supreme Court addressed the issue of whether funds held inside an inherited IRA qualify as “retirement funds” within the meaning of the bankruptcy code. The Court held that they are not.

In Clark v. Rameker, Heidi Heffron-Clark, a Wisconsin resident, inherited an IRA from her mother. Ms. Heffron-Clark thereafter filed for bankruptcy and sought to exempt her $300,000 inherited IRA from the bankruptcy estate under the federal bankruptcy exemption laws. She argued that the IRA exemption applies, so she should be able to exclude the IRA from her bankruptcy estate.

The Supreme Court disagreed. It held that funds held inside an inherited IRA are not retirement funds. But how are funds held inside of a “retirement account” not retirement funds?

To fully understand the decision of the Court and its reasoning, it’s important to understand the difference between a traditional IRA and an inherited IRA.

With a traditional IRA the owner may make contributions until he turns age 70 ½, at which point he is required to start taking distributions (RMDs). Additionally, until he turns 59 ½, if he withdraws any money from his IRA, he faces a 10 percent penalty unless an exception applies.

On the other hand, inherited IRAs cannot receive contributions, so the owner may never invest additional money into the account. Additionally, regardless of the new owner’s age, he must take periodic distributions from the account or fully distribute it within five years. Finally, there are no penalties for taking distributions prior to age 59 ½.

After taking into account the differences between traditional IRAs and inherited IRAs, the Court looked at what it means for funds to be defined as “retirement funds.” It held that the term means “money set aside for the day an individual stops working.” It reasoned that funds inside an inherited IRA, which must be distributed either within five years from the original owner’s death or stretched throughout the life of the beneficiary, couldn’t possibly be set aside for a later date.

The Court also looked at the characteristics of an inherited IRA to determine whether funds held inside such an account could be viewed as money set aside for retirement. The Court pointed to three aspects of inherited IRAs to show that such IRAs are not retirement funds.

      • The holder of the inherited IRA may never invest additional money in the account.
      • The holder of the inherited IRA must take RMDs.
      • The holder of the inherited IRA may take distributions at any time without penalty.

Because inherited IRAs are much more restricted than traditional or Roth IRAs, the Court found that an inherited IRA should not be considered a retirement vehicle. Therefore, the funds inside an inherited IRA are not retirement funds for federal bankruptcy purposes and are not protected from creditors.

What is the lesson of the Clark case? Inherited IRAs are not protected under federal law during bankruptcy. States may still carve out their own exemptions for inherited IRAs, though.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – May 28

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: I have a client who received $100,000 as the beneficiary of his deceased wife’s life insurance policy. My client and his wife were in bankruptcy at the time of her death. Will the death benefit be protected from both of their creditors?

Answer: It depends on the state law and other facts surrounding their situation.

For example, consider the recent Alabama bankruptcy case, In re White, in which a married couple was in Chapter 13 bankruptcy when the wife died. Prior to filing a petition for bankruptcy relief, the debtors purchased a $50,000 life insurance policy on the life of the wife through the husband’s employer. The wife was the insured and policy owner, while her husband was designated as the sole beneficiary.

The wife died and the husband received $50,000. Ordinarily, money received during a bankruptcy plan would go to the bankruptcy estate and the trustee would dictate where that money was allocated. However, the husband asserted that the funds were exempt from the bankruptcy estate because of the following state asset protection statute:

(b) If a policy of insurance . . . is effected by any person on the life of another in favor of the person effecting the same . . . the latter shall be entitled to the proceeds and avails of the policy as against the creditors, personal representatives, trustees in bankruptcy and receivers in state and federal courts of the person insured. If the person effecting such insurance . . . is the wife of the insured, she shall also be entitled to the proceeds and avails of the policy as against her own creditors, personal representatives, trustees in bankruptcy, and receivers in state and federal courts.

Alabama Code Section 27-14-29(b). The statute is rife with legalese, but here’s a translation: if the husband effects a life insurance contract on his wife’s life and names himself as the beneficiary, then the death benefit is exempt from both of their bankruptcy estates.

The husband argued that he “effected” the policy because it was purchased through his employment and paid for with payroll deductions. The bankruptcy trustee disagreed, claiming that the $50,000 death benefit should go to the bankruptcy estate—not to whomever the debtor-husband wants.

The bankruptcy court agreed with the trustee, reasoning that although the wife purchased the policy through her husband’s employment, and, although it was funded with payroll deductions, the policy was owned by the wife, and it was therefore not effected by the husband. Therefore, this particular Alabama creditor exemption did not apply to the husband, and the $50,000 death benefit was not protected from his creditors. (Note that it was protected from his wife’s creditors, but since they were jointly in bankruptcy, that made no difference.)

The White case reinforces the idea that a policy’s death benefit, when paid to a beneficiary going through a bankruptcy, might also be lost to creditors. The court’s decision hinged on its interpretation of the Alabama state law bankruptcy exemption and the ownership of the life policy on the deceased wife’s life. It probably never occurred to the husband in this case that policy ownership might make a difference as to whether he might be able to keep the death benefit later on. Even though state bankruptcy exemptions provided some protection for life insurance proceeds, the specific circumstances of this case didn’t extend those protections to the surviving husband.

Finally, the decision serves as a reminder (again) to life insurance professionals to

  • Review the ownership and beneficiary designations of all their clients’ life insurance and financial products on a regular basis.
  • Consider naming a spendthrift trust as beneficiary instead of the individual directly to protect beneficiaries who might have future financial difficulties.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.