Tuesday, June 21, 2011

Losing Bankruptcy Protection On Your IRA

You probably know that monies in your IRA are protected from bankruptcy. No one intends to go there, but it’s nice to know that you have that safeguard.

What do you have to do to void that protection?

Enter Ernest Willis and his IRAs (Willis v Menotte).

Willis opened a self-directed IRA with Merrill Lynch in March, 1993. On December 20, 1993 he withdrew $700,000to help him with a real estate transaction. On February 22, 1994 he put the $700,000 back in the IRA.

NOTE: Let’s count the days… 12 + 31 +22 = 65 days. You may remember that you can withdraw money from your IRA and not have it count as a distribution IF you replace it within 60 days. Looks like Willis missed his count.

In January, 1997 Willis had problems with the stock market. He had to put money into his brokerage account (I presume he was on margin), so he wrote checks back and forth between his IRA and the brokerage account. The settlement takes a few days, so he could keep the brokerage account afloat by swapping checks. Since he was replacing the IRA monies within 60 days, he did not have a distribution.

Somewhere in here Willis partially rolled-over his Merrill Lynch account to AmTrust and Fidelity.

In February, 2007 Willis filed for bankruptcy. The creditor wanted his IRA. Willis said NO NO and NO. The IRA is protected by Bankruptcy Code Section 522(b) (4) (A). “Go away” says Willis.

The bankruptcy court takes a look at the IRA transactions. An IRA is not allowed to participate in certain transactions (called “prohibited transactions”) with its fiduciary. Guess what? If you direct a self-directed IRA, you are a “fiduciary.” Willis tapped into his IRA and did not replace the money within 60 days. The 60 days is not a suggestion; it is the statute. He didn’t make it. He put the money back in there, but this was not horseshoes. This was a prohibited transaction.

The court was also not too amused with the check swapping scheme and his brokerage account. The court observed that this had the effect of a loan between Willis and his IRA. An IRA cannot loan money, and it especially cannot loan money to its fiduciary. This was a prohibited transaction.

The bankruptcy court held against Willis. He appealed to the district court. That court sustained. Willis next appealed to the Eleventh Circuit, and the circuit court has just sustained the district court. Willis has lost.

How much money was in these IRAs? The Merrill Lynch account alone was over $1.2 million.

I have known clients to “borrow” from their IRA, and I especially remember one doing this while Rick and I worked together at another firm a few years ago. I remember counting down and sweating the 60 days. This was a sensitive client, and – if it blew up – I was going to take massive damage. Willis unfortunately did not keep it to 60 days. He must have been strapped, because he wound up borrowing from friends and family. He put the money back into the IRA, but he had missed the window. The later episode with the check swapping was just icing on the cake.

The court pointed out that once the IRA was tainted, the taint followed the partial rolls to the other two IRAs. His three IRAs were unprotected and could be actioned by his bankruptcy creditors.

Willis thought he was clever. He got schooled, and the tuition was expensive.

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