California Drastically Reduces Creditor Exemptions For Qualified Accounts

On September 24, 2024, the California governor signed into law AB 2837 which made certain changes to the California Enforcement of Judgments Law (known as the “EJL”). Most of these changes relate to consumer and medical debt, which I typically don’t deal with and so let somebody else comment upon those changes. There were also, however, changes made to CCP § 704.115 which relate to tax-qualified retirement plans and are of significant interest. These changes will go into effect on January 1, 2025.

Note that these changes do not, repeat do not, apply to retirement plans that are not tax-qualified. These changes may not, repeat not, apply to many pension plans. Here is the new § 704.115(a)(4) which defines the tax-qualified plans which have lost most of their protection:

“(4) Retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Sections 403, 414, or 457 of the Internal Revenue Code of 1986, as amended, to the extent the amounts held in the plans, annuities, or accounts do not exceed the maximum amounts exempt from federal income taxation under that code and are not otherwise exempt under federal law.”

These are the tax-qualified plans and accounts that are the subject of this article.

Prior to AB 2837, most tax-qualified retirement plans were completely exempt from creditor judgment enforcement. Additionally, the distributions from those tax-qualified retirement plans were similarly exempt from creditor judgment enforcement. What this meant was that if a debtor had funds in a tax-qualified retirement plan, then creditors could not get at those funds and the creditor could not get at those moneys once they were distributed either.

What were partially exempted from this protection, prior to AB 2837, were the Individual Retirement Account (IRA ― including a Roth IRA) and certain Simplified Employee Pension (SEP) plans. These IRAs and SEPs had only a partial protection (if at all) because they were subject to the so-called means test of § 704.115(e).

The means test queried how much money the debtor and dependents would require to live in retirement. While this sounds pretty good at first, the problem is that the means test also looked at all the debtor’s other income and assets to determine how much this amount should be. Thus, if the debtor had an IRA but also a company-sponsored retirement plan, the odds were good that none of the IRA would be protected on the rationale that the company-sponsored retirement plan would take care of the debtor’s needs in retirement. Or, if the debtor was under 60 and could theoretically make up the amount in earnings until retirement, then the SEP or IRA would not be protected.

Let me digress and say that because of the cost of living in California, the amounts that the California courts will protect for the debtor’s retirement ― even if the debtor has no other sources of retirement income ― is often absurdly low. The court opinions are all over the board, but suffice it to say that my own rule-of-thumb is that the amount that will be protected will typically be no higher than $250,000. This may be a lot if you are living in rural Arkansas, but is not much to get you by for 25 years if you are living in any California metropolitan area or along the coast. Which is about 95% percent of the California population.

What AB 2837 did was to apply the means test of § 704.115(e) to all tax-qualified retirement plans. Thus, tax-qualified retirement plans that were fully-protected before are fully-protected no more. Instead, the California courts will now look at these plans as well to determine how much money the debtor will need in retirement. This is a huge and very negative change for California debtors who have such plans.

But hold on! These tax-qualified accounts that are now subject to the means test are almost always ERISA plans, and the ERISA anti-alienation provision operates to keep creditors from enforcing judgments against moneys while they are held in an ERISA plan. Being federal law, ERISA controls over contrary state law ― including the EJL. So money is still safe in ERISA plans while it stays in the ERISA plan.

The problem arises when there is a distribution from the ERISA plan to the debtor. While ERISA may protect money that is in an ERISA plan, it does not protect those moneys after they are distributed. Those moneys thus become fair game for creditors under the state laws.

This is where there has been the biggest change with AB 2837. Previously, the distributions from an ERISA plan were exempt from creditor judgment enforcement under § 704.115(b). After AB 2837, those ERISA plan distributions are still exempt from creditors, but they are not wholly protected anymore. Instead, the same means test analysis of § 704.115(e) now applies to ERISA plan distributions as well. In other words, an almost minimal protection for the funds held in an ERISA plan.

What all this means is that a debtor who has a dischargeable debt and a lot of money built up in their tax-qualified retirement plan will have to consider bankruptcy as an option. Bankruptcy may offer greater protections for tax-qualified retirement plan assets than will be available under California law. Further, bankruptcy may wash out creditors prior to any distributions being made from an ERISA plan. Caveat, however, my oft-repeated warning that bankruptcy is the most dangerous place for a debtor with assets to be, and one should really think this through with the help of experienced bankruptcy counsel before they pull that particular trigger.

The thin silver lining in all this is that AB 2837 extends one protection to the tax-qualified plans that are no longer fully exempt: Federal and state taxes attributed to the distribution will come off the top and the amount the creditor will receive will be reduced accordingly. This was true for IRAs and SEPs and it now is true for all tax-qualified plans as well.

Well, there you have it. California residents who had tax-qualified plans will go to bed on New Year’s Eve knowing that their tax-qualified plans were fully protected from creditors, but when they wake up on New Year’s Day those plans will be barely protected at all.

What this means for asset protection planning in California is that tax-qualified retirement accounts of any type are now highly susceptible to creditor attack. What is still protected in California is a retirement account that is not tax-qualified. Asset protection planners must now take that into account in their planning, and quit presuming that tax-qualified plans are protected for California residents.