401(k) accounts are exempt in bankruptcy

The Supreme court has ruled that transfer restrictions contained in ERISA qaulified pension plans remove the accounts from the bankruptcy estate pursuant to section 541(c)(2) of the Bankruptcy Code.

Upon filing a bankruptcy case, a bankruptcy estate is created. The bankruptcy estate becomes the “owner” of all property owned by the debtor when the petition was filed. For the consumer debtor this means that the trustee has control over your property while your case is pending. It is normal practice for the debtor to retain the property while the case moves along, so you won’t have to worry about turning over your stuff to the trustee unless you have property that is not exempt. Does your 401(k) become part of the bankruptcy estate?

It depends on whether it is “ERISA qualified” under the meaning of section 541(c)(2) of the Bankruptcy Code. Section 541(c)(2) provides: “A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non-bankruptcy law is enforceable in a case under the Bankruptcy Code.” Why is a restriction on the transfer of a trust or account relevant? In part because it prevents the sale of the property in satisfaction of creditors claims outside of bankruptcy. Section 541(c)(2) simply carries this protection in to the bankruptcy world. In order to realize a dividend to distribute to creditors, the trustee would have to sell the trust or account. This is prohibited by the plain language of ERISA qaulified 401(k) accounts which do not allow for assignability or transfer while the property is held in trust. You can’t transfer it and keep it in its current tax exempt form and creditors can’t take it in satisfaction of their claim.

In Patterson vs. Shumate, the Supreme court held that ERISA, a federal statute, qaulifies under the definition of applicable non-bankruptcy law. The Court held that ERISA mandated restrictions on the transfer of pensions and 401(k) accounts were the type of non-bankruptcy law to which section 541(c)(2) refers: “a debtor’s interest in an ERISA qaulified pension plan may be excluded from the property of the bankruptcy estate pursuant to 541(c)(2).”

The important lesson for consumers is that your 401(k), if ERISA qaulified, does not become part of the bankruptcy estate. It is not subject to liquidation by the trustee and you will be able to retain it through the bankruptcy process. Be sure to consult an attorney to determine whether your pension is ERISA qaulified.

John O’Connor