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Inherited IRAs and Bankruptcy

Posted Sunday, January 19, 2014 by John S. Palmer

The U.S. Supreme Court has agreed to decide whether debtors in bankruptcy can keep an inherited IRA. The decision is expected to resolve a conflict among the lower courts on this issue.

Generally speaking, upon filing bankruptcy all property of the debtor is considered to be part of the bankruptcy estate and available to pay creditors. However, in order to help provide a fresh start after the bankruptcy is over, debtors are permitted to keep certain property by declaring it exempt from the bankruptcy estate.

The bankruptcy code permits a debtor to keep “retirement funds” if they are in a fund or account that is exempt from taxation under the sections of the tax code that are applicable to IRAs, qualified pension plans, defined benefit retirement plans, and the like. Beyond that, the bankruptcy code does not specifically define what constitutes “retirement funds” as that phrase is used in 11 USC 522, subparagraphs (b)(3)(C) and (d)(12), which create the retirement funds exemption.

Last April, the U.S. Court of Appeals for the Seventh Circuit held that a debtor’s inherited IRA did not qualify as “retirement funds” under these provisions. The court noted that in some cases, inherited IRAs must be liquidated within 5 years; in others it is possible to stretch the required minimum distributions over the actuarial life expectancy of the beneficiary at the time they inherited the IRA; but in all cases, unless inherited by a surviving spouse, the IRA must begin making annual distributions to the new owner within about a year of the original IRA owner’s death, regardless of the new owner’s age. Therefore, the court concluded, “an inherited IRA does not have the economic attributes of a retirement vehicle, because the money cannot be held in the account until the current owner’s retirement.” To treat an inherited IRA as exempt in bankruptcy, the court reasoned, “would be to shelter from creditors a pot of money that can be freely used for current consumption” by its owner.

This decision conflicts with prior decisions by two other Circuit Courts. In 2012, the Fifth Circuit held that an inherited IRA meets the code’s definition of “retirement funds” and is therefore exempt from the bankruptcy estate:

The plain meaning of the statutory language refers to money that was “set apart” for retirement. Thus, the defining characteristic of “retirement funds” is the purpose they are “set apart” for, not what happens after they are “set apart.”

In 2010, the Eighth Circuit reached the same conclusion. It noted that the tax code affords inherited IRAs the same tax exempt status as other types of IRAs, and found it irrelevant that the tax code establishes different rules for taking required minimum distributions from an inherited IRA.

It is the 2013 decision by the Seventh Circuit that has been accepted by the Supreme Court. The case is Clark v. Rameker, Supreme Court docket no. 13-299. The debtor’s petition for certiorari was granted on November 23, 2013. Oral arguments are scheduled for March 24, 2014.

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