Security Interests In Qualified Retirement Plans

November 22, 2010

Submitted by Vincent E. Mauer.  Searching for collateral that might be used to collateralize loans to individuals, clients occasionally ask if an individual borrower may pledge his or her interest in an ERISA-qualified retirement plan, commonly known as, a 401(k), a Roth 401(k), a 403(b) or other similar type retirement plan, or the cousin of an IRA, a Roth IRA. In almost all instances, the safer answer for the lender is to assume that the lender will not be able to obtain and enforce a security interest against assets held by such a plan.

ERISA Plans
If the borrower can withdraw money from the retirement plan without the 10% tax penalty and if you the borrower would, in fact, make those withdrawals and use that money to pay the loan, the lender can consider the retirement plan as a potential source of repayment should the borrower’s income or other assets prove insufficient. That is not the same, however, as considering the plan assets as collateral that the lender may seize if forced to take action to collect the debt.

The Employee Retirement Income Security Act (“ERISA”) requires that every qualified plan have a provision that “benefits provided under the plan may not be assigned or alienated.” 29 U.S.C. § 1056(d)(1). Provisions that meet this requirement are interpreted to keep an individual debtor’s interest in an ERISA qualified plan from the plan participant’s bankruptcy estate because they are those plan provisions are “applicable non-bankruptcy law” that keeps the property from being then available to the debtor. See 11 U.S.C. § 541(c)(2) and Patterson v. Shumate, 504 U.S. 753 (1992). In the vast majority of cases, those same plan provisions prevent a lender from seizing the plan assets when a particular plan participant (i.e. the borrower) defaults on a personal loan.

The Internal Revenue Code contains a similar provision that impacts qualified retirement plans, 26 U.S.C. § 401(a)(13). The IRS regulations concerning this section do not explicitly indicate that an ordinary loan from a third party creditor cannot be secured by the borrower’s interest in a qualified plan. However, the regulations do so implicitly by providing certain narrow types of loans that can be secured. IRS Regulation 1.401(a)-13(d)(ii) provides that if the qualified plan permits loans from the plan, a participant may secure that loan with the participant’s interest in the plan that has not been borrowed. See also the regulations and statutes which permit the alienation of a divorced individual’s interest in a qualified plan through a Qualified Domestic Relations Order (“QDRO”). The old adage expressio unius est exclusio alterius [explicitly stating one item explicitly excludes other items] leads to the conclusion that the IRS believes a generic loan by a third-party lender to a plan participant may not be secured by the participant’s interest in the plan.

IRA and Roth IRA Accounts
The above-discussed principles concerning ERISA may not control the same issue when applied to IRA accounts, because IRA accounts are not sponsored by employers. But those principles and the policies behind them inform the answer concerning IRA accounts.

An IRA is a “trust” and the terms of that trust must provide that the owner’s interest cannot be forfeited. 26 U.S.C. Section 408(a). Moreover, the trust must be “created or organized in the United States for the exclusive benefit of an individual or his beneficiaries.” Many IRA plans that meet these requirements will prohibit the pledging of the IRA account under state law applicable to the pledging of a beneficial interest in a traditional spendthrift trust.

Prior to Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 there was significant litigation concerning the inclusion of IRA accounts in the bankruptcy estates of individual debtors. Those cases generally held that the terms of IRA “trust” documents sufficient to meet the definition of an IRA under the tax code resulted in the exclusion of the IRA’s assets from the debtor’s bankruptcy estate because the IRA’s assets were subject to a “restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law.” 11 U.S.C. Section 541(c)(2).

In the significant majority of situations, the IRA “trust” language that meets (i) the above-discussed IRS’ standards and (ii) the bankruptcy code standards will also meet the spendthrift trust rules under state law that prohibit the granting of a security interest in the IRA “trust” account.

The same provisions that prohibit a plan participant’s interest from being part of that person’s bankruptcy estate and prohibit the granting of a security interest in the participant’s plan account are usually also enforced to prevent the garnishment of this asset. This is typically a state law rule. See, e.g. Ohio Revised Code Section 2329.66. Of course, there are exceptions for the Internal Revenue Service, the payment of certain criminal fines that then permit the seizure of money in qualified retirement accounts.

In addition to the significant probability that state law prohibits the pledging of an IRA account, the IRS also discourages this activity. According to the IRS “if you use a part of your traditional IRA account as security for a loan, that part is treated as a distribution and is included in your gross income. You may have to pay the 10% additional tax on early distributions … .” See IRS publication 590 (2009) Individual Retirement Arrangements in the section titled “Prohibited Transactions.” This IRS statement arises from Internal Revenue Code section 4975 which prohibits the use of the IRA owned assets for the benefit of a “disqualified person,” including the account owner and her beneficiaries. 26 U.S.C. Section 4975. Note also the potential that using the IRA’s assets to secure a loan to the account owner would be a prohibited transaction resulting in the disqualification of the account for IRA status with the resulting tax consequence.

I cannot recommend these strategies, but there are a couple possible limited exceptions: (1) if the ERISA plan permits loans by to the participant, there is some thinking that the participant might be able to “pledge” her right to take a loan from the plan and give the lender a power of attorney to, in fact, take a loan from the plan which right the lender could then exercise if the borrower defaults on her obligations to that lender; and (2) if the IRA or Roth IRA is held at the institution that is also the lender, there may be some rights that the lender can obtain, including set-off rights that would accrue to the lender after the loan is in default because there is some thinking that a set-off against a retirement account is not an alienation or assignment by the planned participant because it is involuntary and arises as a matter of law.

In the final analysis, the best answer is that while retirement account assets may be a source for repayment by the borrower, they should not be relied on by the lender as collateral that can be seized by the lender.

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