In June, the United States Supreme Court determined that Inherited IRAs do not qualify for a bankruptcy exemption, i.e., they are not protected from creditors in bankruptcy. Specifically, the justices ruled unanimously a couple of weeks ago that a Wisconsin woman who had declared bankruptcy could not keep a $300,000 IRA that she inherited when her mother died.
While the Bankruptcy Code does state that a debtor may exempt amounts that are both (1) “retirement funds,” and (2) exempt from income tax under one of several specified Internal Revenue Code provisions (including Code Sec. 408, which provides a tax exemption for IRAs), the issue before the U.S. Supreme Court was whether an IRA that was inherited actually qualified as “retirement funds.”
The Facts. In 2000, Ruth Heffron established a traditional IRA. Ruth died the next year, leaving the $450,000 IRA to her daughter, Heidi Heffron-Clark. Upon receipt of the inherited IRA, Heidi elected to start taking monthly distributions.
Fast forward to 2010, when Heidi and her husband (the “Clarks”) filed a Chapter 7 bankruptcy. In their petition, the Clarks claimed an exemption for the inherited IRA (now worth $300,000 after 9 years of distributions) under Bankruptcy Code § 522(b)(3)(C). However, the bankruptcy trustee and the debtors’ unsecured creditors objected, arguing that that the balance of the inherited IRA was not “retirement funds” under the Bankruptcy Code and, as a result, could not be exempted from the bankruptcy proceedings.
The Clarks initially lost on this argument before the Bankruptcy Court; however, the federal District Court reversed the Bankruptcy Court’s decision and ruled in favor of the Clarks. Then, the Seventh Circuit reversed the District Court, reinstating the Bankruptcy Court’s initial ruling. Ultimately, the case landed in the hands of the U.S. Supreme Court for final resolution.
The Court’s Analysis. The Court began its review by noting that the Bankruptcy Code does not provide a definition of “retirement funds.” As such, the Court turned to the ordinary meaning of the term, stating that “retirement funds” refers to money that is set aside for the time that a person is no longer working. Thus, the determination of whether funds held in an account are “retirement funds” should be based on the legal characteristics of the account holding the funds and on whether the account is one that was actually set aside for when an individual is no longer working.
The Court then identified the following three legal characteristics of inherited IRAs that made funds held in these accounts “not objectively set aside for the purpose of retirement.”
- Prohibition from making additional contributions. Under a standard IRA, the account holder may, and is in fact encouraged, to make additional contributions to the account for his or her retirement. However, the Internal Revenue Code actually prohibits the holder of an inherited IRA from contributing additional moneys to the account.
- Mandatory withdrawals from account. Under a standard IRA, account holders are not required to make withdrawals from the account until they either retire or reach a certain age. However, the holder of an inherited IRA must withdraw money from the account within a certain period after receiving the account, and without regard to whether the account holder is retired or not.
- Ability to take withdrawals without penalty. Standard IRA account holders are subject to a 10% early withdrawal penalty if the monies are taken from the IRA prior to retirement. However, inherited IRA account holders can withdraw the account funds at any time without penalty. As a result, there is no incentive to save for retirement.
Based on the above characteristics, the Court stated that the funds held in the inherited IRA should not be treated as “retirement funds” for purposes of the exemption under the Bankruptcy Code. As a result, such funds should be available for payment of the Clarks’ debts under the bankruptcy proceedings.
Are there still options to protect the inherited IRA?
Yes!!! First, there is a factual exception to the Supreme Court’s ruling that an inherited IRA is not “retirement funds.” In the above case, the beneficiary of the inherited IRA (Heidi) was the daughter of the original account holder (Ruth). However, if the beneficiary of an inherited IRA is the spouse of the original account holder, then the spouse-beneficiary has the option of treating the IRA as his or her own IRA, i.e., a roll-over IRA. If so, the surviving spouse-beneficiary, as the IRA owner, (1) may defer the start of the IRA distributions to his or her own retirement, but (2) like other IRA owners, the surviving spouse-beneficiary may have to pay the 10% early-withdrawal penalty if monies are taken from the IRA before retirement. As such, to the extent the surviving spouse-beneficiary elects to treat the inherited IRA as a roll-over IRA, then the protected, exempt status of the IRA under bankruptcy law should remain in intact.
Second, the original IRA owner can name an irrevocable spendthrift trust as the beneficiary of the inherited IRA. The trust, in turn, holds and distributes the IRA funds for the benefit of the individual spouse, child, or other person that would have otherwise been the direct beneficiary of the IRA. In this manner, the trust is the actual owner of the inherited IRA, and not the individual person. As such, the individual person’s creditors cannot access or attach the inherited IRA. These trusts, known as Retirement Trusts or IRA Inheritance Trusts™, were frequently used prior to the Supreme Court’s decision, but are even more critical now that the Court has opened the doors for a child’s creditors to seize the inherited IRA.
You are invited to contact us for a complimentary appointment to discuss who you should select and designate as the beneficiaries of your IRAs and how you can protect these valuable assets for the ones you love.