Your IRA is at risk

Over the years I’ve written a couple of articles stating, “the sky is falling, the sky is falling,” in reference to IRAs and their status of being protected from creditors.

Well, it appears Spacelab landed with a resounding thunk in Tennessee.

If you don’t remember, my theory has been if a brokerage firm requires an IRA owner to provide a personal guarantee in order to open the IRA, the brokerage firm is causing the IRA to engage in something called a prohibited transaction with the end result being a distributed IRA.

The loud thunk was generated by a bankruptcy judge in Tennessee who agreed with my analysis. Back in October, the judge determined that the mere act of the debtor agreeing to the terms of a Merrill Lynch account app, caused the IRA to be considered fully distributed for purposes of the tax code and thus no longer an exempt asset for bankruptcy.

Here’s a line from the case, “As incongruous as it appears, based upon the language of the Client Relationship Agreement signed by the Debtor, the mere opening of the Merrill Lynch IRA caused the Debtor to participate in a prohibited transaction under 4975.”

The end result was that the individual filing bankruptcy was ordered to turn over their $61,000 dollar IRA to the bankruptcy trustee.

Let’s take a moment to reflect upon this decision. We now have a federal court deciding that bad language inside an account application can cause an IRA to be fully distributed for tax purposes. A direct result of the IRA being distributed for tax purposes is that the account that used to be known as an IRA is no longer exempt from the claims of creditors.

Wow, talk about the double whammy. You go into bankruptcy because you’re broke. Now, the bankruptcy court takes away all of your IRA to pay off your various creditors. Adding salt to the wound, you now have to pay taxes on the distribution and yet your entire account has been taken away!

There are probably some of you saying that this is no big deal and it can’t happen to too many people. Well, the language the judge used does appear to apply to anyone who opened an IRA with Merrill Lynch whose account app had the same bad language. While I don’t know how many different account apps Merrill has, all the pre 2011 account apps I’ve seen have the bad language in them. To put it another way, if you opened what you thought was an IRA with Merrill Lynch before 2011, you really need to run this issue past your attorney or tax advisor (if they are aware of the issue).

Yes, the case is currently under appeal and there is a chance the decision will be overturned. Additionally, the IRS issued an announcement saying they are not going to enforce these provisions “provided there has been no execution or other enforcement pursuant to the agreement against the assets of an IRA account of the individual.” Apparently, what this means is that if you don’t have any creditor issues, the IRS won’t consider your account distributed, however if you do have creditor issues the IRS will consider your account distributed. This is one of the stranger caveats I’ve seen the IRS put on an announcement.

If you want certainty in your life you might want to consider requesting a private letter ruling saying that your IRA isn’t distributed. This is going to be costly if you have an IRA over $100K, but it is going to be a lot cheaper than the taxes on the IRA or the complete loss of the IRA due a creditor coming after it.

In closing, some very strange things are happening in the IRA world. There is a high likelihood that this is all going to blow over and amount to nothing. However, there is also a chance that due to overzealous drafting of your brokerage application you stand to lose a large amount of your nest egg.