Monday, August 29, 2011

Chapter 7 Bankruptcy, Taxes, and the IRS: Your Retirement Plans

What happens to your retirement funds when you file for Chapter 7 bankruptcy? And what happens if the IRS also has tax liens filed against your retirement funds?

Generally when you file for Chapter 7 bankruptcy, your retirement plans (Individual Retirement Accounts, Roth IRA, 401k, SEP, Keogh plans, etc.) are protected.  Neither the bankruptcy trustee nor any of your creditors can reach the money in these retirement plans.  However, as we discussed in another blog post, “Tax Liens & Your Home,” tax liens survive a Chapter 7 bankruptcy if there are funds/assets/property to which the liens attach.

So what happens when the IRS files a lien which attaches to your retirement funds after you file for Chapter 7 bankruptcy?  This is a situation where an irresistible force (IRS lien) meets an immovable object (retirement funds).  The answer:  The IRS lien stays.  This means that the IRS rights to the retirement funds are unchanged from before the bankruptcy.

However, all is not lost because you have defenses to the IRS seizures of retirement accounts after bankruptcy.

How You Can Defend Your Retirement Money from the IRS

1.  If you can’t touch it, neither can the IRS.  
Your primary defense against an IRS retirement account seizure is that the IRS stands in your shoes as it relates to their ability to take your property, including retirement accounts.  The IRS has the same rights to your property that you have – if you have no rights to an asset, neither does the IRS.  This applies equally to whether the IRS is seeking a post-bankruptcy enforcement of a tax lien or just a straight seizure without any bankruptcy involvement.
 The IRS may have a tax lien on your retirement account, but has no right to enforce if you have no right to the property.  Therefore, you should be aware of which of your retirement funds you cannot touch and which funds you can touch – but with a penalty.  Many 401(k) plans, and all of your IRA/Roth IRA funds can be withdrawn by you – but with a penalty. Because you can withdraw these funds, even if it is with a penalty, the IRS can enforce the tax lien on these accounts.  On the other hand, many pensions (especially for government entities or union pensions) cannot be touched until the occurrence of some event (separation from employment, death, or disability), and therefore the IRS cannot enforce the tax lien against these accounts

2.  You can convince the IRS to leave your retirement funds alone.  
According to the Internal Revenue Manual, the IRS considers three factors when determining whether to enforce its lien against your retirement account (by seizing or levying).  The three factors are:
 1)    Other Collection Alternatives:  Before levying on a retirement account, the IRS is required to first consider collection alternatives before levying on the retirement plan, including monthly payments.  The IRS generally does not desire to take retirement accounts; it tends to make for bad public policy. 
2)    Your Conduct was Not Flagrant:  The IRS is generally interested in taking retirement accounts only if the conduct leading to the tax liability was flagrant. The IRS generally wants retirement accounts to pay a tax liability in cases of egregious behavior. Contributing to the retirement account while the unpaid taxes were accruing and a history of employment tax problems are factors in favor of account seizure. 
3)    Mercy Rule:  The final factor in whether the IRS will take a retirement account is whether you depend on the money in the retirement account, or will depend on it in the near future. Again, the IRS tends to be sensitive to retirement account seizures, and proving that the money in the account is important to meeting everyday living expenses can be a factor to keeping the money.

Again, a tax lien which survives your bankruptcy does not mean that you will be destitute in your retirement.  In practice, the IRS will often just let these liens die away once the bankruptcy case is closed.  However, if they do not, you are usually in a good position to make some alternate arrangement (since your financial situation should be better) or convince the IRS to leave your retirement funds alone. 

Do you have questions about this topic? Email or call me for a free consultation and we can discuss your situation. (760) 990-1632

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