Retirement Plans: Old Stand-By for Asset Protection and Other Developments

Author: Nadia A. Havard

Originally published in October 2022

Copyright © 2022 Knox McLaughlin Gornall & Sennett, P.C.

Retirement Plans Are Another Asset Protection Trust

Trust Asset Protection Afforded by Federal Law to Retirement Plans

Federal law provides robust protection to qualified retirement plans within and outside bankruptcy proceedings. Since 1938, the Internal Revenue Code (the “Code”) has required that the assets of a qualified pension, stock bonus, or profit-sharing plan held in a trust to be managed for the exclusive benefit of the employees and their beneficiaries, and that trust funds are not to be diverted for purposes other than the exclusive benefit of employees ….” (BNC 365-3rd, p. A-1; 26 U.S.C. 401(a)(2)).

In 1974 the Congress passed the Employee Retirement Income Security Act of 1974 (the “ERISA”), that codified “fiduciary requirements imposed under earlier federal legislation”. ERISA further strengthened asset protection for qualified retirement plan assets by imposing the anti-alienation rule. Title I of ERISA provides that “a pension plan shall provide that benefits under the plan may not be assigned or alienated”. (ERISA section 206(d); 29 USC Section 1056(d)(1). “When enacting ERISA in 1974, Congress found that “the growth in size, scope, and numbers of employee benefit plans in recent years has been rapid and substantial”, rendering the “scope and economic impact of such plans” increasingly more interstate and national in nature”. (In re Estate of Sauers, III, 32 A.3d 1241, quoting 29 USC Section 1001(a) at 201).

In addition to the ERISA’s anti-alienation rule, Code section 401(a)(13)(A) provides that “a trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that benefits provided under the plan may not be assigned or alienated”. Furthermore, Treas. Reg. 1.401(a)-13(b)(1) clarifies that a plan without anti-alienation clause will fail to be a qualified plan. “[A] trust will not be qualified unless the plan of which the trust is a part provides that benefits provided under the plan may not be anticipated, assigned (either at law or in equity), alienated, or subject to attachment, garnishment, levy, execution or other legal or equitable process”. (Treas. Reg. 1.401(a)-13(b)(1)).

Qualified retirement plans covered by the ERISA and the Code include pension, profit sharing and section 401(k) plans. However, if a plan covers only owners and no common-law employees, such plans are outside the ERISA anti-alienation protection. The ERISA anti-alienation and preemption provisions make state attachment and garnishment laws inapplicable to an individual’s benefits under an ERISA pension plan.

Qualified retirement plans that are NOT covered by the ERISA and the Code include (i) owner-only plans, (ii) individual retirement arrangements (“IRAs”), (iii) simplified employee pension plans, (iv) governmental plans, and (v) most church plans. (ERISA sections 4(b) and 201; Code Section 401(a), DOL Reg. Section 2510.3-2(d)).

As applied to bankruptcy, there are federal statutes that address creditors’ right and their access to debtors’ assets. Under the ERISA’s non-alienation clauses, most assets in a tax-qualified retirement plan are not considered part of the estate in a bankruptcy proceeding, meaning they are not available to pay creditors’ claims. There is a bit of a catch, however – the ERISA covers plans, and not benefits, according to Supreme Court of the United States. This means that once ERISA-eligible plan begins to pay out, there is no anti-alienation clause to cover the funds anymore and creditors can reach the funds like any other assets in a debtor’s estate.

Another federal law that covers qualified retirement plans in bankruptcy is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). This Act exempts certain retirement plan assets from a debtor’s bankruptcy estate: assets held by a Section 401(a) tax-qualified retirement plan, a Section 403(b) annuity plan, a section 457(b) eligible deferred compensation plan, or certain IRAs under Sections 408 or 408A (traditional IRAs, Roth IRAs, SEPs and SIMPLEs). It is important to note, however, that inherited IRAs, as opposed to a traditional IRA or a rolled-over IRA, are not covered under BAPCPA.

Trust Asset Protection Afforded by State Laws to Retirement Plans

Pennsylvania, like many other states, protects retirement plans from creditor claims. Section 42 PA.C.S. 8124 excludes retirement plans and IRAs (to certain extent) from creditor claims.

“If a plan benefits only self-employed owners in a Keogh plan or shareholders/employees in a corporate plan (where ERISA protections are inapplicable), it may be prudent to transition plan assets to IRAs. (“Creditors’ Rights Tax Qualified Plans and IRAs”, by Mark P. Altieri and Richard A. Maegele, The CPA Journal, 2005).

As with bankruptcy, once a retirement plan begins to pay out, creditors are generally free to pursue those funds. A key difference is that outside of a bankruptcy context, state law governs the issue of which funds are exempt from actions such as garnishment or a judgment creditor. In Pennsylvania, 42 Pa.C.S. § 8124 (“Section 8124”) covers creditor rights outside bankruptcy.

Section 8124 exempts several kinds of insurance payouts from the reach of creditors: for general insurance policies they can only reach payouts exceeding $100 per month; creditors cannot access any group insurance policy or proceeds; and accident and disability insurance payouts are likewise off the table. Tax creditors cannot touch life insurance payouts to cover income tax deficiencies. Also, annuity contract or life insurance payments made to or for the benefit of a spouse, children, or dependents of the insured are exempt from creditors (although this exemption does not apply if the judgment creditor is himself/herself the spouse, child or dependent of the debtor).

Retirement funds and accounts (outside of certain types of public employee pensions, which have their own rules) are also covered under Section 8124. Importantly, the statute says that any pension or annuity that a private corporation or employer pays to a retired employee is exempt from the reach of creditors if the pension/annuity is “not assignable”. This means that the plan should have a non-alienation clause stating that no benefit under the plan is subject to attachment, garnishment, levy, etc. nor can an interest in the plan be transferred to another.

There are also certain types of IRS qualified retirement and annuity plans that are shielded from non-bankruptcy creditors in Pennsylvania. These include plans covered under sections 401(a), 403(a) and (b), 408, 408A, 409 or 530 of the Code. There is a bit of a wrinkle with this however, as the shield doesn’t cover amounts contributed by the debtor in excess of $15,000 in one year, unless the excess funds were directly rolled over from another exempt fund or plan. Also, and not surprisingly, amounts that are “deemed to be fraudulent conveyances” are not covered by the statute.

Exception to Asset Protection of Retirement Plans

Qualified Domestic Relations Orders (“QDRO”), as defined in the Code Section 414(p), override anti-alienation provisions (Code Section 401(a)(13)(B) and ERISA section 206(d)(3)). A QDRO can alter the way that assets are protected from creditors. A domestic relations order is one that relates to provisions such as alimony, child support, and other marital property rights.

Under ERISA, if such a domestic relations order is qualified (QDRO), a part or all of a retirement plan can be paid out to the “alternate payee” – spouse, child, etc. To be qualified, the domestic relations order needs to be issued by a state authority, which is usually a court. The alternate payee who is designated to receive part or all of the benefits has to be a spouse, former spouse, child or other dependent. The order has to contain certain information such as the number of payments, mailing addresses, and so on.

Also there are some restrictions as to what it cannot do – such as require a plan to provide for increased benefits or pay out benefits in the form of a qualified joint and survivor annuity for the lives of the alternate payee and his or her subsequent spouse (if it is a separate interest QDRO). Once all these boxes have been ticked, the order is a QDRO and the normal ERISA protections regarding retirement plans change. The normal ERISA anti-alienation protections against creditors do not apply to QDROs according to 26 U.S.C. § 401(a)(13)(B) since they allow the participant’s creditor (i.e. a spouse) to access the participant’s retirement plan assets.

Sometimes questions arise whether a property settlement agreement (“PSA”) entered into by a participant and to be ex-spouse and which is incorporated in a divorce decree constitutes a QDRO. The distinction also needs to be made between the “survivor benefits” QDRO and “separate interest” QDRO. These are quite different in what rights the former spouse will hold to the participant’s pension plan.

In Files v Exxonmobil Pension Plan, the Third Circuit of Appeals clarified that if PSA seeks to grant survivor benefits to the ex-spouse, such survivor benefits need to be included in PSA and, thus, determined, as of the date of the plan participant’s death. (Files v Exxonmobil Pension Plan, 428 F3d 478 (2005), at 486 quoting Samaroo case (Samarro, 193 F.3d at 189). However, “ERISA … does not insist that a state court recognize a former spouse as an alternate payee to such an interest in her spouse’s pension but merely yields to the prerogative to do so by state courts”. (Id. at 482, n.5). “Nor does ERISA limit the plan benefits that may be addressed within state court domestic relations orders to “survivor benefit”.) (Id.).

In Files case, the PSA” conferred upon [former spouse] fifty percent interest in [the participant’s] pension, in other words “conveying to her a portion of … [husband’s] interest in the plan “ thus giving the former spouse “a separate interest in fifty percent of [husband’s] pension” as of the date of PSA. (Id. at 488). It also weights on whether PSA creates survivorship rights in pension plan or whether the former spouse has separate interest in the pension plan. The Court further stated that “[n]othing in the statute or in our precedent, requires that a QDRO be in place prior to the death of a plan participant when that [domestic relations order] that is ultimately obtained by engaging the statutory process simply seeks to enforce a separate interest in a pension benefit that existed before the death of the plan participant”. (Id. at 491.)

Like with most aspects of asset protection (and life generally), timing can be crucial. If a debtor gains an interest in a pension plan through a QDRO after filing for bankruptcy, this interest is generally considered a part of the bankruptcy estate and therefore may be available to creditors. But if this QDRO interest comes about before filing for bankruptcy, courts have considered it excluded from the bankruptcy estate. Interestingly, the timing of the death of an ERISA plan participant does not seem to matter as much, as appellate courts have decided that there is nothing preventing an alternate payee from pursuing a portion of a pension plan after the death of the participant so long as the pension plan interest existed before the death.

In re Burgeson (In re Burgeson, 504 B.R. 800 (2014)), the Bankruptcy Court for Western District of Pennsylvania held that since the debtor was neither the participant of the pension plan nor a designated beneficiary of such plan, and filed to obtain QDRO prior to filing her bankruptcy petition, her interest in the former spouse’s pension plan awarded under QDRO did not exempt it from bankruptcy creditors. (Id. at 805). The Bankruptcy Court quoted the Superior Court of Pennsylvania that “[a]part from the survivor benefit …. ERISA does not mandate that other benefits be provided to a participant’s spouse … ERISA creates no substantive rights in the case of divorce, but only accommodates, by the provisions governing QDRO’s rights, created by state marital law” (Id. quoting Holz v Holz, 850 A 2d 751, 762 n.5 (Pa. Supr. 2004), appeal denied, 582 Pa. 700, 871 A.2d 192 (2005) (citing Edmonds v Edmonds, 184 Misc 2d 928, 931, 710 NYS2d 765, 769 *NY Sup. Ct. 2000). Compare with In re Nelson (274 B.R. 709 (2002). The 8^th Circuit Court determined that the retirement plan benefits awarded to the alternate payee under QDRO which was obtained by the alternate payee prior to filing the bankruptcy petition are exempt from the bankruptcy estate under ERISA anti-alienation provisions. (Id. at 798).

Federal tax levies and judgments can cover retirement benefits under Code Section 401(a)(13) and Treas. Reg 1.401(a)-13(b). However, in the Chief Counsel Advisory memorandum 200032004 and FSA 199930039, the IRS advised that a retirement plan does not have to honor an IRS levy for taxes to the extent that the taxpayer is not entitled to an immediate distribution of benefits from the plan.

Criminal or civil judgments, consent decrees, and settlement agreements may permit the offset of a participant’s benefits under a plan and order the participant to pay the plan.

A fiduciary violation or criminal activity will require offset payment, subject to the participant’s spouse’s written consent if the participant is married at the time of offset and if the survivor annuity provisions of ERISA section 205 or Code section 401(a)(11) apply. (Code Section 401(a)(13)(C), ERISA Section 206(d)(4)).

Furthermore, the Mandatory Victims Restitution Act permits garnishment of retirement savings to compensate crime victims. One of the most recent examples is the Greebel case (United States v. Greebel, 2d Cir., No. 21-993, 8/24/22) “A former Katten Muchin Rosenman LLP lawyer convicted of conspiring with Martin Shkreli to commit securities fraud can be forced to put part of his $921,000 retirement accounts toward his $10.4 million restitution order, the Second Circuit ruled.” Shkreli Co-Conspirator Lawyer Must Use 401(k) for Restitution (bloomberglaw.com)

(As a background, “[a] federal judge ordered notorious “Pharma Bro” Martin Shkreli banned for life from the pharmaceutical industry and also ordered him to pay $64.6 million in profits he earned from hiking the price of the drug Daraprim; ..Shkreli earned widespread condemnation in 2015 for raising Daraprim’s price from a wide range of people, including former President Donald Trump and then-Democratic presidential contender Hillary Clinton.”)

“Evan Greebel’s 401(k) accounts from his years working at Katten and at Fried, Frank, Harris, Shriver & Jacobson LLP are subject to garnishment under the Mandatory Victims Restitution Act [“MVRA”], the US Court of Appeals for the Second Circuit held. The MVRA permits garnishment of retirement savings that would otherwise be protected by the Employee Retirement Income Security Act, the court said.” Shkreli Co-Conspirator Lawyer Must Use 401(k) for Restitution (bloomberglaw.com)

“The court’s opinion considers the intersection of the MVRA, which authorizes courts to award reimbursement to crime victims, and ERISA, which protects retirement savings held in employer-sponsored plans from being “assigned or alienated” for other purposes. In allowing portions of Greebel’s retirement accounts to be garnished, the Second Circuit acted in line with earlier decisions by the Fourth and Ninth circuits.´ Shkreli Co-Conspirator Lawyer Must Use 401(k) for Restitution (bloomberglaw.com)

“Greebel, who was convicted in 2017 of conspiring with Shkreli to defraud investors in Retrophin Inc., argued that the government couldn’t access his retirement accounts because he doesn’t currently have a unilateral right to withdraw that money. The appeals court largely disagreed, saying this argument was based on a “series of tortured contract interpretations.” Shkreli Co-Conspirator Lawyer Must Use 401(k) for Restitution (bloomberglaw.com)

Inherited IRAs. Pennsylvania courts have recently confirmed that inherited IRAs are available to creditors to satisfy their claims against debtors. In Jones v McGreevy, the Superior Court of Pennsylvania stated that although Pennsylvania “protects retirement funds and accounts from attachment or execution by judgment creditors” (Jones v McGreevy, 270 A.3d 1 (2022), at 18 citing 42 Pa.C.S. 8124 (b)), the purpose to provide debtors with basic necessities of life rather than give a free pass to debtors does not cover inherited IRA. The Pennsylvania Superior Court adopted the reasoning of the US Supreme Court in Clark case stating that “[t]he very purpose of the exemptions under the federal Bankruptcy Code, which is “to provide a debtor with the basic necessities of life so that she will not be left destitute and public charge [Clark at 129 n3, 134 S. Ct. 2242] … is also served by this Commonwealth’s analogous exemptions under section 8124, which are likewise intended to protect an individuals’ retirement income from execution by creditors” (Id. at 21 citing In re Barshak, 106 F. 3d 501, 504 (3d Cir. 1997) (citing in re Houck, 181 H.R 187, 193 (Bankr. E.D. Pa.1995)

(“The Pennsylvania legislature has made a policy decision that, for purposes of state law, IRAs should be insulated from involuntary [alienation] via a creditor’s execution”). The Superior Court reasoned that since “subsection 8124(b)(1)(ix) contains sustainably similar language to the statutory bankruptcy exemption under section 522(b))” (Id. at 21), inherited IRAs are not protected from creditor’s claim in Pennsylvania whether within or outside bankruptcy proceedings. (Id. at 22).

Recent Case Law Focusing on Retirement Plans and Creditor Claims Within and Outside Bankruptcy

There have been some recent court cases that have addressed the treatment of ERISA assets in a bankruptcy context. The main takeaway from these cases is just how important timing is for bankruptcy asset protection when it comes to 401(k)s — when a beneficiary withdraws funds from a 401(k) account, and when someone starts and stops making payments into their account, can have important ramifications in a bankruptcy context. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) extended bankruptcy protection for retirement funds in tax qualified retirement plans and IRAs. In non-bankruptcy situations, the tax qualified retirement plans governed by ERISA are protected from state attachments and garnishment proceedings under anti-alienation provisions of ERISA. The IRA assets are protected, if at all, under state laws governing such assets.

Bankruptcy Context

BAPCPA exempts from bankruptcy estate assets held by a Section 401(a) tax qualified retirement plans, a section 403(b) annuity plans, a section 457(b) eligible deferred compensation plans, SEPs and SIMPLE IRAs (with no limitation on the amounts) and IRAs (including traditional and Roth IRAs) up to $1,000,000 (equal to $1,512,350 in 2022 as adjusted for cost of living).

Rollovers from tax-qualified retirement plans are exempt from bankruptcy estate regardless of the amount. Rollover from SEP or SIMPLEs will be exempt up to the amount applicable to contribution IRAs. Since BAPCPA exempts assets held in tax-qualified retirement plans, it is important to have retirement plans continue to qualify as such. Some bankruptcy courts took a position that an opinion letter issued to prototype or volume submitters is not the equivalent to of an individualized determination letter issued to retirement plans. (GA, MA and IL). As such, debtors with domicile in those states will have to demonstrate that their retirement funds indeed are held by qualified plans (such as the lack of the IRS or court determination that the plan fails to qualify as a tax qualified plan and the plan is in substantial compliance with the IRS Code.)

On the other hand, some bankruptcy courts took a position that IRS Rev. Proc. 2005-16 allows employers adopting a prototype or volume submitter plan to rely on the plan opinion letter in determining the tax-qualified status of such plans. (AZ and CA). In light of the split, it is important for plan advisors to remind employers of the need to be in compliance with Department of Labor (“DOL”) and Internal Revenue Service (“IRS”) rules.

For example, the US Fifth Circuit Court of Appeals held in In the Matter of Don Royal Plunk that a bankruptcy court can determine whether the retirement plan has lost its tax-qualification and thus, is not exempt from bankruptcy estate and creditor claims. Also, minimum required distributions (“MRD”) and hardship distributions are not protected from the bankruptcy claims since they are not eligible for roll-overs, but plan loan repayments are exempt from bankruptcy stay since such plan loan repayments are not discharged in bankruptcy. Inherited IRAs are usually not protected in bankruptcy (see Clark v Rameker and Jones v. McGreevy). However, if a surviving spouse rolls over the inherited IRA into her own, such IRA will be exempt from the bankruptcy claims up to the amount authorized by statute ($1,512,350 in 2022).

In re Gilbert, August 23, 2022 (marital property division followed by bankruptcy):

One of the most recent cases, In re Gilbert (In re Gilbert, 2022 WL 3637569, Bank. Ct. NJ 2022), is quite instructing. Mr. Gilbert and his former spouse participated in a defined benefit plan (DB) and a defined 401(k) contribution plan sponsored by a company owned by Mr. Gilbert. Although the details are quire sparse, it looks like Mr. Gilbert’s spouse was not eligible to participate in either of the plans. In 2020, the third party administrator (“TPA”) informed Mr. Gilbert that DB must be amended to bring the DB plan in compliance with its operations. Sometime around 2020, Mr. and Ms. Gilbert entered into a marital settlement agreement (“MSA”) which later was incorporated into the divorce decree. Under the MSA, Ms. Gilbert “transferred” all of her interest that she might had in DB and 401(k) plan to Mr. Gilbert. In April of 2021 Mr. Gilbert filed Chapter 7 bankruptcy and claimed that his DB account (with about $1.6 mil) and his 401(k) account (about $43 k) were excluded from the bankruptcy estate and not available to pay his creditors.

The bankruptcy trustee filed a lawsuit attempting to bring both, DB and the 401(k) plan into the bankruptcy estate based on the fact that both plans failed to operate as qualified tax-exempt retirement plans under the Code. The bankruptcy court disagreed with the trustee that in order to be protected from creditors DB and a 401(k) plan must have not only the anti-alienation provision (as required under ERISA), but also be in compliance with the IRS as tax exempt qualified retirement plans. The bankruptcy court relied on the US Supreme Court decision in Patterson (Patterson v Shumate, 504 US 753, 112 S. Ct. 2242, 119 L. Ed. 2d 519 (1992)), as well as the Third Circuit Court decision in Velis v Kardanis (Velis v Kardanis, 949 F.2d 78 (3^rd Cir. 1991), that DB and 401(k) are excluded from the bankruptcy estate by Section 541(c)(2) if they are covered by ERISA regardless whether or not such plans are tax-exempt qualified retirement plans under the Code and IRS Treas. Reg. This is a very powerful decision since the debtor ended up sheltering about $1.7 mil of his retirement benefits from his creditors based on the fact that both plans complied with ERISA anti-alienation provisions, although, operationally, they might have failed to continue as tax-exempt qualified retirement plans under the Code and the IRS Treas. Regs.

Another point to take away from this decision is the importance of asset division in the divorce. In the Gilbert case the MSA agreement specifically allowed Mr. Gilbert to retain his DB and 401(k) plan assets and for his former spouse to receive their marital residence. As the bankruptcy court mentioned, the MSA agreement “arguably demised the assets available to creditors by granting [the former spouse] the exclusive right to the marital home (part of which would have been a [bankruptcy] estate asset) in exchange for her relinquishing her interest in the retirement accounts (which the court has found are not property of the [bankruptcy] estate). (Gilbert, at 10). The court noted that the bankruptcy trustee could have pleaded that the MSA was a preference or fraudulent transfer but failed to do so.

In re Dockins, June 4, 2021 (inheriting 401(k) followed by bankruptcy):

Kirk Morishita was in a relationship with Holly Corbell for several years. Eventually, the relationship ended and Corbell married Chris Dockins. In 2020, Morishita passed away. At the time of his death, Morishita had a 401(k) account and Corbell-Dockins was the designated beneficiary. Corbell-Dockins was notified of this in March of 2020, and in April the Dockins filed for Chapter 7 bankruptcy. At the meeting of creditors the next month, their attorney informed the Trustee of the 401(k) account. After the meeting, the Dockins did not amend their Schedule B to reflect the existence of the inherited 401(k) funds, on the grounds that the money was not property of the estate. The Trustee disagreed and eventually filed a motion with the court asking that the Dockins be required to turn over the inherited funds.

The question is when a person going through bankruptcy proceedings inherits 401(k) funds from a non-spouse, are those funds part of the estate and therefore liable to be paid out to creditors?

The court decided no, the inherited 401(k) funds were not part of the estate and therefore the debtor Dockins did not need any special exemption in order to keep the money. The court explained that 401(k) funds have certain protections under the ERISA. What is crucial is not so much if the origin was a non-spouse or if the funds were inherited or not, but timing. Because ERISA protects benefits only while in the hands of the plan administrator, the court pointed out that any funds withdrawn by the beneficiary before filing for Chapter 7 bankruptcy are considered part of the estate. But here, Corbell-Dockins did not withdraw the funds or even know how much was in the 401(k) until after filing for bankruptcy. Therefore, the creditors were not able to go after the $35k + that she inherited from Morishita. This case demonstrates just how important the timing of withdrawals can be for asset protection, and that is keeping money in the inherited 401(k) plan can shelter assets from creditors.

Penfound v. Ruskin, August 10, 2021 (401(k) contributions excluded from disposable income to pay off the creditors):

John Penfound worked for a company from 1993 to 2017, during which time he made regular contributions to the 401(k) plan the company provided. In 2017, however, Penfound transitioned to a new company which did not offer a 401(k), therefore no payments were made. In May of 2018, Penfound moved on to a third company, one which did offer a 401(k) plan. At some point, although it is not clear when exactly, Penfound began making regular payments into his 401(k) account. In June of 2018, Penfound and his wife filed for Chapter 13 bankruptcy. As part of their petition, the Penfounds wanted to exclude $1,375.01 a month from their disposable income as voluntary contributions to John’s 401(k). The Trustee did not agree with this assessment, and insisted on the amount being included in the disposable income. The lower courts sided with the Trustee, and the Penfounds appealed that decision. The district court agreed with the lower court, and the Penfounds appealed to the Sixth Circuit Court of Appeals, which made the final decision.

If a debtor had made contributions to a 401(k) plan in the past, but was unable to do so in the six months leading up to filing for bankruptcy, can such debtor exclude any voluntary contributions to the 401(k) made after filing from the projected disposable income?

The lower courts had it right. When deciding how far back to look at 401(k) contributions, six months before filing is the maximum amount of time to take into account. Therefore only the recurring 401(k) contributions made during these pre-filing six months are protected from creditors in a Chapter 13 bankruptcy. When filing for bankruptcy, the six months leading up to filing are looked at to determine how much disposable income a person has that can be, post-filing, paid to their creditors. Because John Penfound was not making voluntary 401(k) contributions in the six months before his filing, he could not then after filing start making voluntary 401(k) payments from his wages and also have that amount deducted from his disposable income.

Again, we see how timing is crucial for ERISA asset protection. Even though John had not been making payments during the six months before filing for the good reason since his company did not offer a 401(k) plan (and not because he simply decided to forgo contributions), this circumstance was irrelevant in reaching the court decision. Those six months of non-payments meant that any voluntary 401(k) contributions made after filing for bankruptcy could not be shielded from his creditors under Chapter 13.

Outside Bankruptcy

ERISA will protect tax-qualified plans from state garnishment and attachments under the anti-alienation provisions. However, IRAs will be subject to state laws. Also, special attention should be given to owner-only plans.

Although BAPCA exempts all tax-qualified plans from bankruptcy claims, whether they are owner-only plans or otherwise, in a non-bankruptcy context the owner-only plans may be exposed to the owner’s creditor claims. “Department of Labor Regulations provide that a husband and wife who solely own a corporation are not employees for retirement plan purposes. The regulations further provide that a plan which covers only partners or only a sole proprietor is not covered under Title I of ERISA.

However, a plan under which one or more common-law employees (in addition to the owners) are participants will be covered under Title I and ERISA protections will be applicable to all participants (not just the common-law employees). Thus, inclusion of one or more non-owner employees transfers a non-ERISA plan into an ERISA-qualified plan and thereby protects the plan assets from the claims of creditors”. (“Creditor Protection of Retirement Pan Assets”, by Richard A. Naegel and Mark P. Altieri, 31 No. 3 Prac. Tax Law, 21 at 25 (2017) citing 29 CFR 2510.3-3(b), (c)(1)).

State law outside the bankruptcy context governs IRAs. Pennsylvania law, for example, exempts IRAs provided that contributions made to an IRA within one (1) year before the debtor files for bankruptcy are exempt only up to $15,000. (42 Pa.C.S. 8124).

Also, any prohibited transactions (“PT”) between an IRA owner (or a beneficiary) and the IRA will disqualify an IRA as such, and thus, the IRA assets will lose creditor protection. “If the owner (or beneficiary) of an IRA engages in any transaction that is prohibited under Code Section 4975 (a “PT”), the IRA ceases to be an IRA as of the first day of the taxable year in which the transaction occurs. This means the special tax benefits accorded the IRA are lost. On this occurrence, the value of the IRA, determined as of the first day of the taxable year for which the account or annuity ceases to be an IRA, is treated as distributed to the IRA owner (or beneficiary, in the case of an IRA for a deceased participant). Thus, the loss of status as IRA may result in loss of creditor protection for assets of the (former) IRA. If there is even one minor PT, the rules are that the entire IRA is treated as terminated and all of its assets distributed to the owner on the first day of the year in which the PT occurred.

In re Ernest W. Willis, the US Eleventh Circuit Court of Appeals affirmed the judgment of a US Bankruptcy Court in Florida that as a result of a PT an IRA lost its status as an IRA and thereby lost its exemption in bankruptcy.) ((“Creditor Protection of Retirement Plan Assets”, by Richard A. Naegel and Mark P. Altieri, 31 No. 3 Prac. Tax Law, 21 at 27 (2017) citing IRS 4975(e)(1), IRC 408(e)(2)(B), and 2011 WL 1522383 (11 Cir. Apt. 21, 2011)).

Summary of IRA Protections – General Rule

Within a bankruptcy context, (i) traditional and contributory IRAs and Roth IRAs are excluded from the bankruptcy estate under BAPCPA up to $1,000,000 as adjusted every 3 years, (ii) IRAs funded from rollover of a previously ERISA protected retirement plans do not count toward traditional IRA limits and are entirely excluded by BAPCPA, and (iii) inherited IRAs are not excluded from the bankruptcy estate (see Clark and McGreevy).

Outside a bankruptcy context (i) traditional and contributory IRAs are excluded based on the state law (PA excludes them from creditors under 42 Pa.C.S. 8124) up to $15,000), (ii) rollover IRAs from ERISA plans are also protected from creditors under state law (PA excludes them from creditors under 42 PA.C.S. 8124), and (iii) inherited IRAs are not protected from creditors in PA (see McGreevy case).

Summary of ERISA Governed Plan Protections – General Rule

Within bankruptcy, ERISA governed plans are protected both under ERISA and BAPCPA. Also, inherited 401(k) plan is excluded from the debtor’s bankruptcy estate (see In re Dockins). If contributions have been made on a regular basis to a 401(k) plan within 6 months of filing for bankruptcy, the debtor may continue making such contributions and have them excluded form ”disposable income” available to pay off the creditors. (See Perfound v Ruskin).

Outside bankruptcy, ERISA governed plans are protected under ERISA except for QDROs and IRS levies.

Other Pointers to Minimize Creditor Exposure - Beneficiary Designation

What Happens If You Forget to Change the Beneficiary

Courts have applied two different standards in determining whether a change in the beneficiary designation occurred. If a plan is covered by ERISA, the courts require strict compliance with the plan documents and procedures adopted thereunder as applied to beneficiary designations and their changes. If a plan is not covered by ERISA, such as an IRA, the courts, including a PA Superior Court, apply substantial compliance standard, i.e. the participant’s intent may be given deference under certain circumstances even though prior beneficiary designation is still in place.

If the retirement plan in question is covered under ERISA, then the plan as written stands supreme, and the funds go to the named beneficiary. Although some states, such as Pennsylvania, did have laws on the books that accounted for cases where a person’s life circumstances have changed (for instance, divorce) and they forgot to change retirement plan beneficiaries before passing away, those laws have been thrown out the window by ERISA. Supreme Court of the United States has repeatedly held that the words of the plan as written are all that matter for ERISA purposes, as a way of providing stability and uniformity in accordance with Congress’s design for ERISA. So it is very important to ensure that beneficiary designations are up-to-date for retirement plans, including insurance policies under welfare benefits plans.

In re Estate of Sauers, III, the PA Supreme Court held that ERISA preempted 20 PA.S.C. Section 6111.2 (dealing with automatic revocation of the beneficiary designation of a former spouse upon divorce) in distributing life insurance proceeds under employee benefit plan. (In re Estate of Sauers, III, 32 A.3d 1241 (2011)). In Sauers, III, the decedent obtain a $40,000 life insurance policy from Hartford Life Insurance Company pursuant to an employee group benefit plan. The plan was an ERISA governed plan. Later, the participant married and named his then spouse as the primary beneficiary and his children from prior marriage as contingent beneficiaries.

Four years later he and his spouse got divorced. The participant passed away shortly thereafter intestate and without changing the primary beneficiary. The plan administrator paid the life insurance proceeds to the former spouse and the estate of the decedent filed a law suit against the former spouse to recover the proceeds. The PA Supreme Court held that:

• the plan administrator was obligated by ERISA to administer the plan in accordance with its terms and, thus, pay the proceeds to the named primary beneficiary (ie.. former spouse), and
• the estate cannot force the former spouse to surrender such proceeds since she was entitled to them under ERISA law.

PA law that would have treated the former spouse as predeceased upon divorce as related to ERISA governed plans is preempted by ERISA. (In re Sauers, III, at 213). “A key purpose of ERISA, therefore, is to provide uniform administrative schemes for employers, plan administrators, and fiduciaries to follow in administering and processing employee benefit plans”. (Id. , referring to US Supreme Court decision in Fort Halifax Packing Co. v Coyne, 482 U.S. 1, 9, 107 S. Ct. 2211, 96 L. Ed. 2d 1 (1987)). The PA Supreme Court followed the decision of the US Supreme Court in Egelhoff (Egelhoff v Egelhoff, 121 S.Ct. 1322, 149 L. Ed. 2d 264, 69 USLW 4206 (2001)), that had very similar fact patterned and the state statute of Washing State, almost identical to PA law. In Egelhoff, the US Supreme Court held that Washington statute providing for automatic revocation, upon divorce, of any designation of a spouse as beneficiary of nonprobate asset was preempted, as it applied to ERISA benefit plans. Benefits must be paid in accordance with plan documents as required by ERISA and state laws requiring otherwise are preempted by ERISA.

The Eight Circuit ruled in favor of the plan administrator in one of the most recent court cases dealing with payment of retirement plan benefits under 401(k) plan to a former spouse of the participant under a beneficiary designation on file with the plan administrator. (Gelschus v. Hogen, No2022 WL 3712312, August 29, 2022). The plan participant and her spouse entered into a marital termination agreement (“MTA”). Under the terms of the MTA, her spouse waived all of his rights to all of her retirement benefits, including a specifically identified 401(k) plan. Prior to the divorce, the participant’s spouse was named as the primary beneficiary.

Subsequent to the divorce, the participant submitted a change of beneficiary designation form to her plan administrator. The plan required that all allocation percentages must be whole percentages. The participant’s beneficiary designation form provided for 33 1/3% payable to each of her siblings. As a result, the plan administrator did not process the form and repeatedly notified the participant about her former spouse continuing to be her primary beneficiary. The participant died 12 years later and the plan paid about $600,000 to her former spouse. The estate sued the plan administrator for breaching a fiduciary duty by failing to change beneficiaries on the account. The estate also sued the ex-spouse to recover the paid benefits.

The court sided with the plan administrator in rejecting the change of beneficiary designation form and on paying the retirement benefits to the former spouse. The court cited the US Supreme Court case Kennedy v Plan Adm’r for DuPont Sav. & Inv. Loan (555 US 285, 3001; 129 S. Ct. 865; 172 L. Ed. 2d 662 (2009), to support the administrator’s decision not to give deference to the participant’s request to pay fractional percentages to her beneficiaries. The court stated that “[t]he point is that by giving a plan participant a clear set of instructions for making his own instructions clear, ERISA forecloses any justification for enquiries into nice expressions of intent, in favor of the virtues of adhering to an uncomplicated rule: “simple administration, avoid[ing] double liability, and ensur[ig] that beneficiaries get what’s coming quickly, without the folderol essential under less certain rules”. (Kennedy at 2).

The court also noted that the plan administrator did not abuse its discretion by following the plan’s instructions to distribute benefits in accordance with then existing beneficiary designation on file even though the plan administrator was aware of the MTA terms. The plan administrator called and later sent 12 annual statements to the participant indicating that the former spouse continued to be named as the primary beneficiary on her 401(k) plan account. The plan administrator also promptly contacted the participant with instructions on how to submit a valid designation. By quoting Matschiner case earlier decided by the same Eight Circuit, the court stated that “[t]he plan provided an easy way … to change the designation, but for whatever reason [the participant] did not [follow through]”. (Manschiner v Hartford Life & Acc. Ins. Co., 622 F. 3d 885, 889 (8^th Cir. 2010) at Gelshus at 3). As such, regardless of the MTA, the plan administrator did what it was required to do, i.e. pay the benefits to the beneficiary in accordance with the valid designation.

The participant’s estate also brought a claim against the former spouse to recover the paid benefits by claiming a breach of contract, unjust enrichment, conversion, and civil theft. The court dismissed claims of unjust enrichment and civil theft.

It is of the utmost importance to follow the plan terms in changing beneficiary designation and having a former spouse waive his/her rights to such benefit, In Kennedy v Plan Administrator for DuPont Savings and Investment Plan (555 U.S. 285 (2009), 129 S.Ct. 885; 172 Ed.2d 662), the US Supreme Court stated that neither the change of beneficiary designation for the pension plan benefits nor former spouse’s rights to pension benefits were waived in form authorized by the pension plan. (Id. at 304). As such, the pension plan administrator was required to pay pension benefits to a former spouse in accordance with the then existing beneficiary designation on file. “A key purpose of ERISA, therefore, is to provide uniform administrative schemes for employers, plan administrators, and fiduciaries to follow in administering and processing employee benefit plans”. (Id. , referring to US Supreme Court decision in Fort Halifax Packing Co. v Coyne, 482 U.S. 1, 9, 107 S. Ct. 2211, 96 L. Ed. 2d 1 (1987)).

The facts of the case are quite informative. A participant named his spouse as the primary beneficiary for his ERISA governed pension plan. Upon divorce, the divorce degree divested the former spouse of “all right, title, interest, and claim in and to …[a]ny and all sums … the proceeds [from] , any other rights related to any … retirement plan, pension plan, or like benefit program existing by reason of [the participant’s] past or present or future employment”. (Id. at 289). Subsequent to the divorce, the participant filed a new beneficiary designation form naming his daughter as the primary beneficiary. The plan allowed any beneficiary to disclaim their interest in the plan benefits in a form prescribed for qualified disclaimers under the Code.

The US Supreme Court emphasized that since ERISA attempted to simplify plan administration by following the plan instruments, including beneficiary designations, instead of interpreting the parties’ intent or underlying state law, the divorce decree failed to amount to a qualified disclaimer under the Code. Also, the act of naming a new beneficiary without removing an existing one, failed to change the beneficiary designation for the plan benefits. As such, the plan administrator “properly disregarded the waiver [i.e. the divorce decree] owning to its conflict with the designation made by the former husband in accordance with plan documents”. (Id. at 288).

Here is an example of the plan language dealing with beneficiary designations: “Automatic revocation of spousal designation. A divorce decree revokes the Participant's prior designation, if any, of his/her spouse or former spouse as his/her Beneficiary under the Plan unless: (a) a QDRO provides otherwise; or (b) the Employer in Appendix B elects otherwise. This Section 7.05(A)(1) applies solely to a Participant whose divorce becomes effective on or after the date the Employer executes this Plan unless: (i) the Plan is a Restated Plan and the prior Plan contained a provision to the same effect; or (ii) regardless of the application of (i), the Employer in Appendix A provides for a special Effective Date for this Section 7.05(A)(1). If the beneficiary designation of a spouse or former spouse is revoked under this paragraph, the remainder of the beneficiary designation remains in full force and effect; the designation shall be applied as though the spouse or former spouse predeceased the Participant.”

In the latest case, a divorce agreement waived the wife's interests in the husband's 401(k) plan. Est. of Kensinger v. URL Pharma, Inc., 674 F.3d 131, 132-33 (3d Cir. 2012) (“[T]he parties mutually agree to waive, release, and relinquish any and all right, title and interest either may have in and to the other's IRA account(s), or any other such retirement benefit and deferred savings plan of like kind and character, and neither shall make any claim to possession of such property as it is presently titled.”). The ex-husband died shortly after the divorce, leaving the ex-wife as his designated beneficiary. Kensinger, 674 F.3d at 133. Benefits were distributed to the ex-wife, and the ex-husband's estate sued her. The question was: “after the plan administrator distributes the funds to [the ex-wife], can the estate attempt to recover the funds by bringing suit directly against [the ex-wife] to enforce her waiver?” Id. at 132 (alterations added). The Third Circuit allowed the suit to proceed, reasoning that the goals of the plan documents rule—“straightforward administration of plans,” “avoidance of potential double liability,” and “expeditious payment of plan proceeds”—are irrelevant to post-distribution suits against recipients of ERISA benefits. Id. at 136-37.

Later state and federal appellate court cases consistently held that ERISA does not preempt post-distribution suits against recipients. See e.g., Andochick v. Byrd, 709 F.3d 296, 300 (4th Cir. 2013) (“[W]e conclude that permitting post-distribution suits accords with the ERISA objectives discussed in Kennedy.”); Metlife Life & Annuity Co. of Connecticut v. Akpele, 886 F.3d 998, 1007 (11th Cir. 2018) (“This court likewise held as mandated by the Supreme Court in Kennedy that a party who is not a named beneficiary of an ERISA plan may not sue the plan for any plan benefits. A party, however, may sue a plan beneficiary for those benefits, but only after the plan beneficiary has received the benefits.”); Moore v. Moore, 297 So. 3d 359, 365 (Ala. 2019) (“As shown in Kensinger, supra, ERISA has no bearing on an estate's post-distribution breach-of-contract action against a spouse regarding the proper ownership of distributed benefits.”)

In re Estate of Easterday, the PA Supreme Court confirmed that in order to invoke beneficiary revocation on the life insurance policy by operation of PA law due to the death of the policy holder during the divorce proceedings with the beneficiary, the grounds for divorce must be established prior to the policy holder’s death. (In re Easterday, 653 Pa. 143 at 153 (2019)). PA Supreme Court also confirmed that the estate of the pension plan participant can recover pension benefits paid to the former spouse under the beneficiary designations based on the state law breach of contract claim in light of the former spouse waiving all her rights to pension plans in the property settlement agreement entered into prior to the participant’s death. (Id. at 169).

These rulings are quite informative since (i) they emphasize the need to have a robust property settlement agreement and (ii) require attention to prompt compliance with all statutory procedures related to obtaining a divorce decree and changing beneficiary designations. The PA Supreme Court stated that “[o]nce the plan administrator makes payment in accordance with the plan documents, it satisfies ERISA’s goals of regulating employee benefit plans and the administration thereof, protecting the plan administrator from double liability, and ensuring that the named beneficiary receives her benefits in a prompt manner….There is no indication that in drafting ERISA, Congress was concerned with the named beneficiary’s right to retain the benefits. To the contrary, this consideration is wholly beyond the scope of ERISA because it is beyond the scope of plan administration. ERISA does not preempt a state law breach of contract claim to recover funds that were paid pursuant to an ERISA qualified employee benefit plan”. (Id. at 169).

IRAs, on the other hand, are not covered by ERISA and so there is a different beneficiary designation dynamic for those. In Pennsylvania, courts take the decedent’s intent into account in determining the beneficiary designation on non-ERISA non-probate assets. In some cases where the decedent had been attempting to change beneficiaries before passing, but for some reason (such as the broker neglecting to send out the right paperwork to be signed) was unable to, the clearly intended beneficiary is favored over the named beneficiary.

In re Estate of Golas (In re Estate of Golas, 751 A.2d 229 (2000)), the PA Superior Court held in favor of an estate of an IRA owner and upheld its claim to the IRA proceeds. The IRA owner was diagnosed with a pancreatic cancer. Shortly thereafter he updated his estate planning documents leaving most of his assets via his will to an educational fund. An estate planning attorney advised the client to change beneficiary designations on various non-probate assets, including an IRA, in favor of the estate. The decedent managed to change beneficiary designations on two of his non-probate assets. However, he did not change the beneficiary on his IRA due to repeated delays by his broker to provide the required form. Prior to his death, the owner called his broker’s office a number of time and requested the form. Upon his death, the owner’s sister continued to be named as an IRA beneficiary.

The Superior Court stated that “[i]n general, one must follow the requirements specified by the policy in order to validly change the beneficiary. … However, the law in this Commonwealth is also clear that “[t]he intent of the insured will be given effect if he does all that he reasonably can under the circumstances to comply with the terms of the policy which permits a change of beneficiary. … Most U.S. jurisdictions follow this equitable principal. … We also note that the formal procedures which an insurance company requires in order to effect a change of beneficiary are in place to protect the company. … Thus an original beneficiary is without the right to insist upon strict compliance with those requirements”. (Id. at 231). The court determined that the decedent substantially complied with the procedures requiring the change of beneficiary designations by contacting his broker’s office on numerous occasions, requesting the beneficiary designation forms and specifically instructing to have the change in place.

Important Points to Know as Related to Retirement Plans

IRS Guidance RE: RMD Rules under the SECURE Act

The IRS issued its Proposed Regulations re changes to required minimum distribution (“RMD”) rules under the SECURE Act on February 24, 2022 (NPRM REG-105954-20). The proposed changes were to apply to calendar years beginning on or after January 1, 2022. For calendar year of 2021, the taxpayers could rely on the existing regulations and good faith interpretation of the SECURE Act.

The proposed regulations provide that if an employee died before December 31, 2019 (the effective date for RMD rules under the SECURE Act), and such employee had more than one designated beneficiary, the SECURE changes will apply upon the death of the oldest designated beneficiary. For example, if an employee left his retirement benefits to a trust which qualified as a designated beneficiary under the old law (i.e. a see-through trust), and such trust has two individuals as its beneficiaries, the SECURE rules limiting distributions in most cases to a 10-year period, will apply only if the oldest trust beneficiary died after the SECURE effective date. If the oldest beneficiary died prior to the SECURE effective date, such trust, and thus, distributions to such trust are grandfathered under the prior RMD rules.

The proposed regulations define the term “minor” as those who have not yet reached the age of 21. Favorably, the proposed regulations allow defined benefits plans that have used a prior definition of age of majority to retain such definition.

With regard to a “disabled beneficiary”, the proposed regulations provide that if as of the date of the employee’s death the Commissioner of Social Security has determined that the individual is disabled within the meaning of 42 U.S.C. 1382c(a)(3), then that individual will be deemed to be disabled for purposes of RMD rules.

There may be some harsh results by not having all beneficiaries of the retirement plan be eligible designated beneficiaries. The proposed regulations provide that if an employee has more than one designated beneficiary and one of them is not an eligible designated beneficiary, the employee will be treated as not having an eligible designated beneficiary. As a result, the employee’s interest must be distributed no later than the end of the tenth calendar year following the calendar year of the employee’s death. However, it is always important to remember that beneficiaries are determined by September 30 of the year following the date of death of the employee.

With regard to defined contribution plans, such as 401(k) or IRAs, the proposed regulations clarify the following:

• If an employee dies BEFORE his/her required beginning date and the beneficiary is a designated beneficiary outside the group of 5 preferential beneficiaries (i.e. eligible designated beneficiaries), such beneficiary does NOT need to take RMDs and the entire account must be distributed in the 10^th calendar year after the employee’s death.
• If an employee dies BEFORE his/her required beginning date and the beneficiary is an eligible designated beneficiary, then the eligible designated beneficiary can stretch over his/her lifetime. Caveat, a defined contribution plan may (i) provide either for the 10-year rule or the life expectancy as related to eligible designated beneficiaries, or (ii) give an employee or an eligible designated beneficiary a choice between a 10-year rule or life expectancy. If the defined contribution plan does not include either of these options, a life expectancy rule will apply to the eligible designated beneficiaries. If the life expectancy rule applies, RMDs must be taken out for the first distribution calendar year for the beneficiary and for each subsequent year.
• If an employee dies ON or AFTER the required beginning date, RMDs must be taken in the first distribution calendar year for the beneficiary and for each subsequent year. If the beneficiary is a designation beneficiary (but not an eligible one), the entire account must be distributed in the 10^th calendar year of the participant’s death. The RMD’s from the date for death until the 10^th calendar year will be based on the beneficiary’s life expectancy.
• If the retirement benefits are left to a see-through trust of which all beneficiaries are eligible beneficiaries, the RMDs can be stretched over the life expectancy of the oldest eligible beneficiary. For example, a single participant leaves his IRA to a trust for the benefit of his brother, and upon his death, his sister. Both siblings are no more than 10 years younger than the participant. The brother is 70 years old and his sister is 69 years old. RMDs can be stretched over the life expectance of the 70-year old beneficiary.

Guaranteed Lifetime Income

Some defined contribution retirement plans may have lifetime income products and features, such as annuities. Some of these payout options are included, sometimes, in the plan’s qualified default investment alternative or by otherwise guaranteeing a portion of the participant’s account balance. However, plan sponsors, fiduciaries and their advisors may be concerned whether these payout options expose them to any fiduciary liabilities under ERISA and if so, whether such products may be removed from the plans.

The SECURE Act provides some assurance for plan sponsors, fiduciaries and their advisors that such guaranteed lifetime income products and features may be included in the plans without causing any exposure to fiduciary liability. As such, a plan fiduciary must act prudently. For example, in case of an insured lifetime income product or feature, the fiduciary must ensure that the insurance company can meet its obligations now, and possibly, for many years into the future. The SECURE sets forth a safe harbor for selection of a “guaranteed retirement income contract” for a defined contribution retirement plan. The SECURE safe harbor may be easier to comply with rather than DOL’s Interpretive Bulletin 95-1.

In addition, if a plan fiduciary determines that such guaranteed retirement income contract should be removed from the plan, the SECURE provides for two different ways to make such product portable and, thus, be removed from the plan. The first option is a direct trustee-to-trustee transfer by a plan of a lifetime income investment option to an eligible retirement plan (e.g. another qualified plan or an IRA). The second option is to allow for the distribution of a lifetime income investment in the form of a qualified plan distribution annuity contract.)

Even though the fees and other compensation associated with insured lifetime income products or features may be higher than those charged for other plan investment options, it is important to determine whether the compensation and other fees are reasonable in light of the product’s benefits and the comparable costs for competitive products.

IRS Pre-Examination Pilot Program

On June 3, 2022, the IRS started a pre-examination pilot program for retirement plans. Under this program, the IRS will notify retirement plan sponsors that the plan will be subject to an upcoming audit. The plan sponsor will have 90 days to review, identify and correct plan document and operational errors. Plan sponsors can self-correct the document and operational failures that are correctable under the EPCRS Self-Correction Program (Rev. Proc. 2021-30). Plan sponsors may request a closing agreement re errors that cannot be self-corrected.

The IRS will use the Voluntary Correction Program (VCP) fees under EPCRS for self-identified errors rather than Audit Closing Agreement Program (Audit CAP) fees that are much higher. If the IRS is satisfied with the plan sponsor’s response and actions, the IRS will issue a closing letter. If the IRS is not satisfied, it will conduct a limited or full scope audit.

If the plan sponsor does not respond to the IRS within the 90-day window, the IRS will start its examination of the plan. As published by Mr. Benjamin Spater on July 18, 2022 “the IRS has unofficially stated that the pilot program presently is limited only to 100 defined contribution plans that have been identified for potential errors relating to compliance with the requirements of Internal Revenue Code section 415 (the annual contribution limit applicable to tax-favored retirement plans).”

It is recommended that the plan sponsors do their own compliance assessment now (including Cycle 3 restatements and interim amendments), including evaluating their practices and procedures. Most recently, the IRS stated that if a qualified retirement plan failed to restate under Cycle 3 restatement, it becomes an individually designed plan. If it has practices and procedures in place, the plan can rely in good faith on the most recently restated plan document while getting its plan in compliance with Cycle 3 restatement.

Plans that may have higher risk of failures include those that:

• Do not have support of an ERISA counsel assisting with document restatements and updates;
• Are small enough to be outside annual ERISA audits;
• Lack plan actuaries or third party administrators;
• Have been frozen for a number of years; or
• Have recently changed payroll or human resource management programs.

New Legislative Bills and Regulatory Changes: Highlights

Employee and Retiree Access to Justice Act, introduced on May 12, 2022 in the House and Senate seeks to ban arbitration and discretionary clauses in ERISA governed benefit plans. “Not only does the bill seek to prohibit benefit plans from requiring arbitration of claims challenging the administration and fiduciary management of the plan, thereby forcing plan disputes into the judicial system, this legislation, if passed, would dramatically alter the long-standing standard of review by court when a plan participant or beneficiary is denied retirement, health, or other benefits under an ERISA-regulated plan”. (“Congress Considers Banning Discretionary Clauses in ERISA Plans” by Sarah Fas, Sarah Martin and Danielle Herring published on May 19, 2022 at www.littler.com/publication-press/publication/congress-considers-banning-discretionary-clauses-erisa-plans).

Under current law, if a plan gives a plan administrator discretionary authority to interpret, construe and apply the terms of the plan, such discretionary decision will be reversed if it is found “arbitrary or capricious”. If, however, the plan does not give such discretion to the administrator, or, if passed, the law will make such clauses unenforceable, then court can review administrator’s decision de novo and reverse it if not reasonable. The bill will also prohibit class action waivers, representation waivers, and arbitration clauses.

Currently the courts give deference to administrators in making decisions. In Hughes v. Northwestern Univ., the court required the participant to plead facts showing that the specific fiduciary decisions made under the then-existing circumstances, might have amounted to a violation of ERISA’s fiduciary standard of care by incurring excessive fees. (Hughes v. Northwestern Univ., No. 19-1401 (S.Ct. Jan. 24, 2022) The Supreme Court directed the Seventh Circuit to reconsider whether each investment option under the diverse menu plan was prudent in the context of the plan’s overall menu of options. The court was asked to opine whether the plan sponsor breached its fiduciary duty of prudence and care. The courts considered whether the fiduciary breached its duty of prudence by (i) having too many investment options on the menu, (ii) having multiple record keepers with proprietary products, and (iii) retaining underperforming investments with high costs.

Here are the key takeaways:

• A large number of the plan investment options [(more than 400 while typical lineups have fewer than 50)] will not shield a fiduciary from its duty to continually monitor and remove or replace poor- performing, high-cost or otherwise imprudent investments from the plan.
• Well documented fiduciary decisions re selection and removal of investments options carried out in compliance with the plan processes and procedures may warrant some deference to fiduciary decisions by courts.
• Investment options offered to retirement plans may become limited. Fiduciaries may decide to stay away from proprietary products.

As the law stands, the courts still give deference to administrator’s decisions. In most recent cases (Albert v Oshkosh Corp., No. 21-2789 (7^th Cir. Aug. 29, 2022) and Rozzo v Principal Life Ins. Co, No. 21-2026 (8^th Cir. Sept. 2, 2022), the 401(k) fiduciaries defeated claims by participants that they breached their fiduciaries duties with respect to high investment fees.

On June 14, 2022, the Senate Health, Education, Labor and Pensions (HELP) Committee approved by unanimous vote the legislation (RISE & SHINE Act) based on the House bill SECURE 2.0. The Senate committee voted on their version of the SECURE 2.0. SECURE 2.0 bill will require employers with more than 10 employees to auto enroll employees. (RISE & SHINE bill does not have that provision). Both bills will allow Long Term Part Time employees to enter the plan after 2 rather than 3 years of service. RISE & SHINE Act, among other things, includes raising the limit on mandatory distributions from $5,000 to $7,000. SECURE 2.0, among other things, includes enhanced credit for small employer retirement plan start up costs, increasing catch-up contributions for those ages 62-64, treating student loan payments as elective deferrals for purposes of matching contributions, increasing the age for required beginning date for mandatory distributions, and requiring at least one quarterly statement delivered in paper, among other things.

The DOL is planning to issue final environmental, social, and governance (“ESG”) rules in December of 2022 addressing permissible use of ESG under ERISA when selecting plan investments.

The “fiduciary rule” dealing with fiduciary advice and prohibited transaction exemptions (PTE 2020-02) will be revisited with regard to definition of fiduciary investment advice and exemptions for prohibited transactions. New proposed fiduciary rule is anticipated to be published by DOL in December of 2022.

Author: Nadia A. Havard

Originally published in October 2022

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