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It's Official: Inherited IRAs Not Protected In Bankruptcy

Posted Monday, June 23, 2014 by John S. Palmer

The US Supreme Court has ruled that inherited IRAs are not an exempt asset in bankruptcy proceedings, thus resolving a split among the lower courts on this issue.

The unanimous decision in Clark v. Rameker (decided June 12, 2014) pertains to an IRA Heidi Heffron-Clark inherited from her mother in 2001. In 2010, she and her husband filed a Chapter 7 bankruptcy petition and claimed the IRA was exempt from paying creditors under the bankruptcy code’s exemption for “retirement funds.” The Clarks’ creditors and the bankruptcy trustee disagreed, setting off a series of appeals. In 2013 the Seventh Circuit Court of Appeals ruled in favor of the creditors; in similar cases two other Circuit Courts had previously ruled in favor of the debtors on this issue.

Justice Sotomayor’s opinion decisively resolves the conflict by ruling firmly in favor of the creditors on this issue. She starts by noting that the bankruptcy code does not define the term “retirement funds” but that its ordinary meaning is “sums of money set aside for the day an individual stops working.” She then states that the issue must be resolved by asking whether the account objectively meets this definition, rather than engaging in a subjective analysis of each individual debtor’s intended use of the funds.

Under this objective analysis, the court found three characteristics of inherited IRAs that “lead us to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement. First, the holder of an inherited IRA may never invest additional money in the account…Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement…Finally, the holder of an inherited IRA may withdraw the entire balance of the account at any time-and for any purpose-without penalty.” In fact, the court noted that Heidi Heffron-Clark had inherited an IRA worth $450,000, but regular distributions had reduced the balance to $300,000 by the time she and her husband filed for bankruptcy.

The court said that applying the bankruptcy code’s exemption for “retirement funds” to traditional and Roth IRAs helps meet the code’s purpose of providing debtors with a “fresh start” after bankruptcy, but:

The same cannot be said of an inherited IRA. For if an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a “fresh start,”…into a “free pass,”…We decline to read the retirement funds provision in that manner.

The decision may not apply to IRAs inherited by a spouse where the surviving spouse elects to treat the IRA as his or her own and defer distributions until reaching retirement age—an option not available to non-spouse beneficiaries. If the intended beneficiary is not a spouse, designating a trust as the beneficiary may offer some bankruptcy protection, provided the trust is drafted carefully; otherwise, it could trigger various negative consequences, including a requirement that the IRA be liquidated in as little as 5 years.

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