Understanding the Illinois Exemption Statute
Most people are aware that retirement benefits are exempt assets protected from the claims of creditors of the plan’s beneficiaries. Jordan Finfer and I have been recently working on a case in which we had to dive deeper into the scope of the Illinois law provides for retirement plans. In doing so, we learned some of interesting facts on how courts apply the Illinois exemption statue (Section 12-1006 of the Illinois Code of Civil Procedure (735 ILCS 5/12-1006)) in complex or unusual situations.
First, let’s review some basics. Retirement plans are fully exempt, with no ceiling or cap, if the plan falls within the statute’s definition of a “retirement plan.” So, the definition is the key. Fortunately, the Illinois statute broadly defines the term “retirement plan”, and courts have construed the statue in manner that will further the clear legislative policy of protecting retirement plans from creditor claims. The Illinois statute is significantly broader than analogous federal statutes which are limited to protecting social security benefits and pension plans that are governed by ERISA. The Illinois exemption protects every type of pension, profit sharing, or retirement account recognized under the Internal Revenue Code (“IRC”); IRA accounts; stock bonus plans; pension plans created under the Illinois Pension Code, which include virtually pension plans established for public employees by Illinois municipalities or units of local government; and plans crated by the government or a church. The exemption statute’s definition of a retirement plan does not create an exhaustive list of protected plans. It permits a court to find that any retirement vehicle created by statute or contract falls within the definition of an exempt “retirement plan” if the plan is intended in good faith to qualify as a retirement plan under the Internal Revenue Code or if it was created under the Illinois Pension Code. All pension plans established by municipalities and units of local government fall within the scope of the exemption.
The exemption protects both the beneficiary’s interest in the plan’s assets and the right to receive distributions from the plan, including returns or refunds of contributions a plan. The protection for returns or refunds is particularly important for plan participants who have the right to withdraw contributions when the beneficiary terminates his employment or participation in the plan, or when the plan is terminated.
The exemption statute does not specifically state whether or not distributions or refunds from a retirement plan remain exempt after the plan participant receives distributions or other withdrawals. Typically, the funds from a distribution or withdrawal are initially deposited into a plan participant’s bank account. Illinois courts and bankruptcy courts applying Illinois law have consistently found that in order to implement the purposes and policies of the exemption statute governing retirement plan, the exemption must extend to funds received by the plan beneficiary, provided that certain basic rules are followed. After a retirement plan beneficiary receives a distribution or refund, the funds remain exempt if they remain in an account that can be traced to the retirement plan and if that account is used for the ongoing support or living expenses of the plan beneficiary. If those conditions are satisfied, the funds remain exempt from creditor claims. The courts reach this result because they have found that the exemption for retirement plans would be seriously eroded if creditors could reach the plan distributions in the hands of the plan beneficiary. However, if the plan beneficiary used distributions or refunds from the plan to capitalize a new business venture, or as a fund for making investments, courts applying Illinois law will probably find that the exemption is terminated. For example, if the plan beneficiary started a business with a $100,000.00 distribution from a retirement plan, the beneficiary’s equity interest in his new business will not be an exempt asset.
The protection the Illinois statute provides to the beneficiary of a retirement plan creates an impenetrable barrier against creditor claims as long as the plan is intended in good faith to qualify under the Internal Revenue Code or is a plan created under the Illinois Pension Code. If the plan can satisfy either of those criteria, then the exemption statute provides a conclusive presumption that the debtors interest in the plan and any distributions from or traceable to the plan is a valid spendthrift trust for the plan beneficiary. Clearly, participants in a pension created pursuant to the Illinois Pension Code have total protection from creditor claims. For everyone else, the hard cases arise from situations where there is some flaw in the creation or funding of a retirement plan recognized under the Internal Revenue Code. This happens in two ways. There can be violations of the contribution limits or a flaw in the creation of the plan. Either form of noncompliance can result in a loss of the exemption, either entirely or partially.
Some retirement plans are self-managed vehicles created by the sole owner of the plan sponsor. These include IRAs, Keoghs, SEP IRAs, SEP 401ks, and pension plans set up and administered by a business in which the owner may be the sole plan participant. What happens if the plan’s owner contributes more than the amount permitted under the applicable provisions of the IRC? This can arise innocently, such as when the plan sponsor or owner makes an honest mistake concerning contribution limits. It can also occur as part of a strategy to take advantage of the unlimited exemption for retirement plans by intentionally making excess contribution, without regard to the IRC limits. In the later situation, the judgment debtor is typically hoping that the judgment creditor will not perceive that the judgment debtor has contributed more than the IRS contribution limits. The majority trend of cases that have looked at a situation where a judgment debtor has contributed more than the IRC contribution limits to a plan have found that plan assets are exempt only up to the point of the IRS contribution limits. Any excess contributions are not exempt. A judgment creditor has recourse against the excess contributions and the proportionate share of the plan’s earnings from the excess contributions to satisfy its judgment.
As already noted, a retirement plan will be immune from creditor claims if it is intended in good faith to qualify under the IRC. Courts have had to set standards to define the point at which non-compliance with the IRC will result in a finding that the retirement plan was not intended to in good faith qualify with the IRC. There are only a few reported decisions on how to determine whether a plan was intended in good faith to qualify. Courts put the burden of persuasion on the debtor (i.e. plan beneficiary) to provide evidence of conduct or action to support a claim that there was a good faith attempt to comply with the IRC. If the judgment debtor is successful, the plan remains fully exempt, notwithstanding technical noncompliance. A judgment debtor could meet this burden by demonstrating that he retained an accountant or pension consultant to set up a valid plan which, through no fault of the judgment debtor contained provisions which did not fully comply with the IRC.
Participants in defined benefit pension and profit sharing plans or 401(k) plans must be particularly vigilant in order to retain the full benefit of the Illinois exemption statue. Pension plans and 401(k) plans will accumulate significantly more value than IRA accounts because of the higher contribution limits. When an employee leaves the sponsor’s employment or when the sponsor terminates a plan, the affected employee has the right to withdraw or rollover the vested plan benefits, which is often a substantial amount of money. If the beneficiary takes a withdrawal, the withdrawn funds should be put into one or more accounts that are traceable to the former retirement plan, and those funds should be used only for living expenses, and not for investment purposes. If the affected employee is going to use the funds in the first plan to fund a new retirement plan such as a rollover IRA (which is another type of fully protected “retirement plan” within the meaning of the exemption statute), the safest course of action is to arrange for a direct trustee-to-trustee rollover from the prior employer’s plan to the new rollover IRA. That will ensure that the full exemption remains intact. Alternatively, the money can be first withdrawn by the employee and then transferred to the new rollover IRA, provided that the rollover IRA is funded within 60 days after the withdrawal from the prior retirement plan. If the plan beneficiary does not setup the rollover within the 60 day safe harbor, the rollover IRA will not qualify under the applicable provisions of the IRC. Therefore, the rollover IRA will be subject to creditor claims unless the plan beneficiary can meet the high burden of establishing that the rollover IRA was intended to qualify, which means being able to convince a court that steps were taken to effectuate the rollover within 60 days and through no fault of the plan beneficiary, the deadline could not be met.
The Illinois exemption statute for retirement plans is perhaps the most significant of all Illinois exemption statutes because there is no ceiling or cap on the amount of the exemption, and because compliance with the statute is relatively easy. There are 3 steps that should be taken to preserve the full extent of the exemption. When funds are withdrawn from a retirement plan they should be put in an account that can be traced to the retirement plan. The withdrawn funds should be used for living expenses. When creating a self-managed pension vehicle such a Keogh, SEP IRA, SEP 401k or rollover IRA, start working with a qualified professional as soon as possible in order to ensure that the retirement plan will qualify under provisions of the IRC. By retaining a certified or licensed professional, you will bolster your chances of convincing a judge that the plan was intended in good faith to qualify with the IRC, thus preserving the exempt status of a flawed retirement plan.