Chapter 7 bankruptcy is a highly effective means of eliminating debt and obtaining a fresh financial start in life. However, the bankruptcy process is complex. This is especially true when it comes to determining what property is exempt (safe from liquidation) and what is not. For Michigan residents filing for Chapter 7 bankruptcy, understanding the rules regarding property exemptions is particularly important.
One area that can be particularly confusing for those filing for Chapter 7 bankruptcy in Michigan is whether a QDRO is exempt. A QDRO, or qualified domestic relations order, is a legal order that divides retirement assets between divorcing spouses.
It is a right to receive money originating from your ex-spouse’s retirement accounts after divorce, in short.
In this Article, we’ll take a closer look at the question of whether a QDRO is exempt in Michigan and especially Detroit-area Chapter 7 bankruptcy proceedings. We will provide an overview of Chapter 7 bankruptcy and exemptions, explain what a QDRO is and how it works, and explore the various factors that can impact whether a QDRO is exempt.
First, let’s lay down some basic information about Chapter 7 bankruptcy and the need to exempt property generally.
Why Must Property Be Exempted in Chapter 7 Bankruptcy?
When you file for Chapter 7 bankruptcy, a “bankruptcy estate” is created by automatic function of law. This “estate” is similar to a probate estate created under Michigan law to determine the disposition of property when someone dies without an estate plan trust or any sort of will at all in place. This bankruptcy estate also includes your property.
That is, the bankruptcy estate includes everything you own as of the date of filing of the Chapter 7 case. Beyond that, it also includes claims for property (i.e., lawsuits) and the right to receive funds. Some common examples of rights to receive funds that must be disclosed and, if possible, exempted in your bankruptcy petition schedules include:
- Wages earned but not yet paid;
- Commissions earned but not yet paid;
- Tax refunds not yet paid;
- … and QDRO distributions.
When you file Chapter 7 bankruptcy, an individual known as a Chapter 7 Trustee is assigned to your case by the Bankruptcy Court. It is the Chapter 7 Trustee’s job to seize the assets of your bankruptcy estate, liquidate them, and to pay the resulting pool of cash to your creditors.
This is why Chapter 7 is known as a “liquidation bankruptcy.” It is the (only) means by which your creditors receive any payment at all when you file Chapter 7.
That all said, most people who file Chapter 7 in Michigan do not lose any property at all. This is because the purpose of Chapter 7 bankruptcy is to help you get a fresh financial start by eliminating your unsecured debt and allowing you to keep “exempt” assets. That is, the US Bankruptcy Code (the Federal statute governing the bankruptcy process) provides for the exemption of certain types of assets to allow you to retain them.
An exempt asset is legally removed from the bankruptcy estate and not subject to seizure by the Chapter 7 Trustee.
Exemptions are specific. There are many of them, but they are not unlimited. The “Federal” exemptions are those listed in the US Bankruptcy Code. Michigan state law also provides a set of exemptions. In Michigan, you can choose between state and federal bankruptcy exemptions, but you cannot mix and match between the two.
What Exemptions Apply to Retirement Accounts Generally?
Only specific types of retirement accounts can be exempted under Federal or Michigan law. Further, the value of the exemptions of available for some retirement accounts is capped, depending upon which exemption is applied.
The Federal exemptions that might be applied to a retirement include:
- 11 USC §522(d)(12): Retirement funds in an account exempt from taxation under IRS Code Sections 401, 403, 408, 408A, 414, 457, or 501(a) are fully exempted. (Thus, for example, a 401(k) account can be exempted without any value cap under this exemption.)
- 11 USC §522(d)(10)(E): Payments under a stock bonus, pension, profit-sharing, annuity, or similar plan on account of illness, disability, death, age, or length of service may be exempted under this statute to the extent reasonably necessary for the support of the debtor and any dependent of the debtor, with exceptions for non-tax qualified plans created by insiders. (Italics here indicate points which may be argued on the facts by a Chapter 7 Trustee.)
- 11 USC §542(c)(2): This provision is not among the Bankruptcy Code’s list of exemptions, but it provides a restriction on the ability of a Chapter 7 Trustee’s liquidation power. Specifically, this provision states that a restriction on the beneficial interest in a trust that is enforceable under applicable non-bankruptcy law is also enforceable in a Chapter 7 or Chapter 13.
Michigan’s exemptions that are applicable to retirement accounts can be found in MCLA Section 600.5451. The relevant subsections are:
- Subsection (k) provides an exemption for any interest in a “retirement or pension plan or account that is exempt from taxation under section 408 or 401(a) of the internal revenue code, 26 USC 408, 401(a), to the extent reasonably necessary for the support of the debtor and any dependent of the debtor.”
- Subsection (l) provides an exemption for any interest in a tax-deferred annuity plan that is a qualified plan under section 403(b) of the IRS Code to the extent reasonably necessary for the support of the debtor and any dependent of the debtor.
If any of these accounts are subject to a court divorce, maintenance, or child support order, the exemption does not apply.
What Is a QDRO?
So what, again, is a QDRO?
The QDRO, or qualified domestic relations order, is an exception to an ERISA rule prohibiting the sale of interests in pensions plans. It was created to protect the financial security of divorcees. Specifically, it is a Michigan court order that “creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan.”
The divorcing spouse receiving a share of his or her now-ex-spouse’s retirement fund is designated as an “alternate payee” of the retirement funds, in other words.
A QDRO is typically ordered in a Michigan divorce proceeding when there are retirement assets to be divided between the parties. If one or both spouses have a 401(k), pension, or other qualified retirement plan, the court may order a QDRO to divide the assets as part of the divorce settlement.
The QDRO is a legal order that specifies how the retirement assets will be divided and distributed to the respective parties.
Note that a QDRO is only necessary for qualified retirement plans, and not for IRAs or other types of retirement accounts. (Why? A QDRO is unnecessary for IRAs because they are not considered “qualified retirement plans” under ERISA. Unlike qualified plans, IRAs are governed by the IRS Code. Because ERISA does not govern an IRA, a QDRO is not required. Instead, the division of IRA assets is typically addressed in the divorce settlement agreement or the court’s divorce decree.)
Can a Right to Receive Funds Pursuant to a QDRO Be Exempted?
So can you exempt your right to receive funds or funds that you have received pursuant to a Michigan QDRO?
Maybe. Much will depend upon the nature of the originating retirement account, annuity, or plan. Even more will depend upon the Judge that is assigned to your case by the Bankruptcy Court.
Over the years, the Eastern District of Michigan Bankruptcy Court has ruled on this issue on at least a few occasions, with varying results depending on which exemption was applied to the QDRO and depending upon the facts at hand.
For example, in 2002, now-retired Judge Rhodes ruled in one case that QDRO funds could be exempted under Section 541(c)(2), described above. Pursuant to a US Supreme Court ruling holding that ERISA-qualified plans are “trusts” for purposes of this exception, Judge Rhodes allowed the debtor in that case to exempt funds received via a QDRO.
This is good news—but remember that part about Judge Rhodes being retired? It is worth nothing that Bankruptcy Court rulings are not precedential. That is, they are not binding on judges’ decision-making abilities in later cases. Only if the 6th Circuit Court of Appeals or the US Supreme Court ruled the same way that Judge Rhodes did would it be safe to say that 542(c)(2) could reliably protect QDRO funds.
More recently, Judge Tucker of the Eastern District of Michigan Bankruptcy Court ruled that 522(d)(12) does not apply to QDRO funds at all. His reasoning was that, pursuant to another US Supreme Court case, these funds did not qualify as “retirement funds” for the purpose of the exemption.
Judge Tucker remains, as of this writing, on the Bankruptcy Court bench in Detroit.
The exemption under 522(d)(10)(E) has not been tested, to our knowledge, by an Eastern Michigan debtor in Chapter 7 in a QDRO scenario.
Protecting a QDRO in Chapter 7 Bankruptcy: The Bottom Line
The bottom line is that, if you have received or are entitled to funds in any appreciable amount pursuant to a Michigan QDRO, you need to retain an experienced bankruptcy attorney to represent you. If the amount of money involved is more than can be exempted with the also-available “wildcard” exemption (maximum approximately $12,000), you can and should expect a Chapter 7 Trustee to attempt to liquidate the funds.
Attorney Walter Metzen is a Board Certified Bankruptcy Expert who has successfully represented thousands of Metro Detroit Chapter 7 and Chapter 13 clients for over 30 years.
If you are considering filing for bankruptcy, contact us now to schedule your free initial consultation.