In a unanimous decision handed down on June 12, 2014 in the case of Clark v. Rameker, the Supreme Court of the United States held that an Inherited IRA does not fall under the exemption afforded to retirement accounts under the Bankruptcy Code and is included in bankruptcy estate.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provided a great deal of protection to assets designated as retirement funds. IRAs, traditional and Roth, received a $1 Million inflation-adjusted exemption, while funds originating from employer-sponsored retirement programs received unlimited protection from creditors.
Up until this point, the courts have split in their treatment of Inherited IRAs. Some held that so long as funds are ‘retirement funds’ held in an account exempt from taxation it was out of reach of judgment creditors. Other courts sided with creditors denying exemption under the reasoning that Inherited IRAs are entirely different from traditional and Roth IRAs (different rules for distribution and taxation) and lack a clear retirement purpose as their funds could be accessed at any time by the beneficiary.
The case involved an Inherited IRA account with about $300,000. Ruth Heffron established an IRA in 2000, which was Inherited a year later by her daughter Heidi Heffron-Clark. In 2010 the beneficiary of the Inherited IRA and her husband filed for a bankruptcy. In their petition, they claimed that the Inherited IRA was not to be a part of the bankruptcy estate. The trustee and creditors of the estate disagreed with that assertion on the grounds that Inherited IRA moneys were not retirement funds.
The Bankruptcy Court sided with the creditors in their 2011 ruling, which was overturned by the US District Court the following year under the reasoning that since the funds were originally saved for retirement they qualified for the exemption. In 2013, that decision was reversed by the Court of Appeals stating that there was a difference between IRAs which were Inherited and the ones which were not. The Supreme Court agreed with the court of appeals upholding their decision.
What the Court Said
Justice Sotomayor, who wrote the opinion, stated that Inherited IRAs are not retirement funds for three reasons:
- New contributions are not allowed to Inherited IRAs;
- Holders of Inherited IRA accounts are required to withdraw money from them, no matter how close or far they are from retirement;
- Distributions from Inherited IRAs are not subject to the 10% premature distribution penalty and can be withdrawn at any time for any purpose;
The Justice further noted that the result was consistent with the purposes of the Bankruptcy Code and its balancing of the interests of creditors and debtors. Reading the retirement fund provision in a different manner would be equivalent to giving debtors a ‘free pass’ and not a ‘fresh start’ intended by the exemption of the Code.
It is tough to argue with that reasoning.
What It May Mean from Now on
This development puts a greater emphasis on asset protection considerations for beneficiary designations and not primarily on tax attributes which arguably played a greater role before the June decision.
- IRA account holders will look to their advisors for help in evaluating risks and rewards when selecting IRA beneficiaries other than their spouse. It will be important to review current beneficiary designations to determine is any changes are in order.
- Spousal beneficiaries will need assistance in examining the merits and risks of treating the Inherited IRAs as their own or designating them as Inherited IRAs. There is uncertainly whether IRA assets inherited by a spouse will be treated as retirement funds or inherited funds.
- Trusts as beneficiary of IRAs may become a more popular option although the rules are complex and a careful risk/reward and cost/benefit analysis will be necessary.
- Some states may choose to act now and offer a level of protection to Inherited IRAs at the state level as the Court’s decision addressed federal bankruptcy rules. Currently, eight states protect Inherited IRAs in bankruptcy: Alaska, Florida, Idaho, Kansas, Missouri, North Carolina, Ohio, and Texas.