April's landmark bankruptcy legislation helped change the world for spendthrift Americans.By virtue of the Bankruptcy Abuse Prevention and Consumer Protection Act, Congress reformed bankruptcy laws by taking away some privileges, and then the U.S. Supreme Court gave some of them back with a ruling that IRAs would be safe from creditors. Both actions have prompted CPA advisors to rethink the strategies available to clients whose finances get out of control.
For one thing, fewer clients may qualify for bankruptcy protection.
"Under the new federal law, bankruptcy is no slam dunk," said Mitchell Freedman, CPA/ PFS, of Mitchell Freedman Accountancy Corp., in Sherman Oaks, Calif. "People with significant assets and income can no longer walk away from their debts."
The means test under the new law for Chapter 7 filing restricts those with incomes greater than their state's median income. Trustees or creditors can bring a motion to dismiss if the filer's income exceeds that. Additionally, filers with higher incomes establish payment plans according to a formula set by the law.
Advisors don't encounter clients in financial trouble very often. While more may seek protection from creditors from lawsuits, most investors show greater financial restraint than the general public. "In 15 years, I recommended bankruptcy fewer than five times, and only one client in fact ever filed," said Freedman. "But with an income over $200,000, he wouldn't be relieved of his entire debt burden under the new law."
Infrequent as the need for bankruptcy advice is, the new laws require a knowledge upgrade. The federal bankruptcy laws have changed, but state laws still differ. Additionally, the IRA protection granted by the court decision will be trumped by items in the bankruptcy bill. Florida law, for instance, always had an unlimited homestead exemption, but the new legislation restricts that amount to $125,000 of equity in homes purchased within 1,215 days of the filing.
"The first thing advisors have to do is understand what the new federal law does relative to their state," said Terrence A. Schultz, CPA, of Berkowitz Dick Pollack & Brant CPAs & Consultants LLP, in Miami.
The bankruptcy law goes further than the court decision to protect retirement assets in IRAs. Individual contributions are off limits to creditors up to $1 million, and rollovers from qualified plans are completely protected. "The media is reporting the negatives for debtors in the new law," said Ed Slott, CPA and publisher of Ed Slott's IRA Advisor Newsletter, in Rockville Centre, N.Y. "But the protection clauses for IRAs are an oasis of good for debtors in this bill."
The actions of Congress and the courts may mean changes in clients' financial plans. Advisors in the 16 states with previously weak protections for IRAs might find more comfort under the new law. While New York had superior creditor protection, investors in Alaska, Arkansas, Connecticut, Hawaii, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, Pennsylvania and Rhode Island, South Dakota, Texas, Vermont, Washington and Wisconsin enjoy greater protections in bankruptcies. State laws still vary for other types of creditor actions.
The new rules tinker with timing, and that means that advisors need an early alert system for clients who show any signs of future financial trouble. The homestead exemption in Florida serves as one example. "Clients who change homes too close to the bankruptcy filing would lose the exemption," said Schultz. "Planners have to be careful that clients don't make fraudulent transfers which might get them into trouble right at the start."
Bankruptcy is expensive
Clients in worsening financial straits also need more money just to go through bankruptcy process under the new law. Filers are required to complete a credit counseling course within 180 days of filing, which extends the time until relief. "If a client is having a problem, planners need to get involved sooner to plan for the possibility under this new law," Schultz advised.
The higher $1 million protected amount in IRAs may prompt advisors to recommend that clients increase their contributions. But since few advisors deal with clients that they expect to have to worry about bankruptcy, this will not likely affect the opinion of many. "I'm less concerned with the credit law because I've always been conservative with clients," said Freedman. "I've also always recommended clients pay into an IRA even if they can't take the full deduction."
Questions remain about the reach of the law.
Some question whether Roth IRAs fit the exempt description. The wording of the law also raises questions about whether account holders past the penalty age of 59 are covered, and what happens after the required distribution age of 70. James A. Shambo, CPA/PFS, of Lifetime Planning Concepts, in Colorado Springs, Colo., said that the new law is favorable for everyone younger than 59, and that it's clear that all withdrawn funds are not protected. But he may change his advice for clients once the issue of treatment for older account-holders is clarified.
"I'll continue doing what I've typically done and counsel clients on the provisions for Colorado," Shambo said. "But if they're thinking of moving to another state, I'd recommend they leave their assets in a qualified plan."
Ironing out the wrinkles
The next few months will answer many questions. Advisors may have a flood of clients wanting to roll delayed funds out of qualified plans, or they may not. There may be a rush of bankruptcies filed to receive treatment under the old law. The age and Roth IRA questions may require more court cases for complete clarification.
"Any new law takes a while to iron out all the wrinkles," said BDP&B's Schultz. "For the next six months, advisors should check out all the implications with an attorney for clients that might be affected."
Slott also speculated that the stronger federal laws might pull up states' statutes.
Expect additional tinkering if the 50 statehouses begin deliberations, but eventual consistency might be worth it to some.
Slott underscored that New York's creditor protection and bankruptcy laws already top the federal codes. "The recent moves by Congress and the court add strength to the state provisions like ours," he contended. "Because of the federal changes, states with strong measures are not likely to be considering ideas of weakening existing laws."
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