US Supreme Court rules inherited IRAs not protected in bankruptcy
The U.S. Supreme Court has ruled that funds held in inherited IRAs are not “retirement funds” exempt from the debtor’s bankruptcy estate under federal law. The Court’s unanimous decision in Clark v. Rameker means that funds held in inherited IRAs are not protected from bankruptcy under the federal bankruptcy statutes and are subject to creditor claims in bankruptcy.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 affords retirement funds significant protection in bankruptcy. IRAs currently receive a $1,245,475 exemption under federal law and cannot be used to satisfy claims of creditors in bankruptcy. The exemption amount is subject to adjustments every three years.
The question that arose in Clark v. Rameker is whether funds held in an inherited IRA are considered retirement funds exempt from the bankruptcy estate under the retirement funds exemption. The Supreme Court decision answers the question, resolving an issue that had become muddled over time as different courts of appeal handed down differing opinions.
In Clark v. Rameker, Heidi Heffron-Clark (the bankruptcy debtor) inherited a Traditional IRA from her mother, who died in 2001, and elected to take monthly distributions. In October 2010, the debtor and her husband filed a chapter 7 bankruptcy petition. They identified the inherited IRA—then worth roughly $300,000—as exempt from the bankruptcy estate. The bankruptcy trustee and some of the debtor’s unsecured creditors objected to the exemption on the grounds that funds in an inherited IRA are not retirement funds under the meaning of the statute.
The Bankruptcy Court agreed and disallowed the exemption for the inherited IRA. The debtor appealed the decision and the District Court reversed the Bankruptcy Court’s decision. The bankruptcy trustee then appealed, and the Seventh Circuit Court of Appeals reversed the District Court’s judgment, thereby creating a split between the Seventh Circuit and the Fifth Circuit. The Fifth Circuit had come to the opposite conclusion in Chilton v. Moser in 2012. The Supreme Court granted certiorari, agreeing to hear the case to resolve the split, and affirmed the Seventh Circuit’s decision.
In its decision, written by Justice Sonya Sotomayor, the Supreme Court noted that the Bankruptcy Code does not define “retirement funds” so the Court looked to the ordinary meaning of the term. After consulting the American Heritage Dictionary, the justices concluded that “retirement funds” is properly understood to mean sums of money set aside for the day an individual stops working. The justices also agreed that to determine whether funds in an inherited IRA qualify as “retirement funds,” courts should not engage in a case-by-case analysis into whether the debtor actually intended to use the funds for retirement. Instead, courts should look to the legal characteristics of an inherited IRA in an objective manner to determine if the account is one that is set aside for the day an individual stops working.
The Court looked at three legal characteristics of an inherited IRA that lead it to conclude that funds held in inherited IRAs are not objectively set aside for the purpose of retirement.
- While IRA owners receive certain tax incentives to contribute on a regular basis to Traditional and Roth IRAs, beneficiaries cannot make contributions to inherited IRAs.
- Unlike IRA owners, beneficiaries of inherited IRAs are required to withdraw money from inherited IRAs, regardless of the number of years left before they retire.
- While a penalty tax applies when IRA owners under age 59½ take distributions, beneficiaries of inherited IRAs may withdraw the entire balance of the account at any time—and for any reason—without penalty tax.
The Court noted that the purpose of the Bankruptcy Code’s exemption provisions is to provide a careful balance between the interests of creditors and debtors. Assets that are exempt from the bankruptcy estate are not available to creditors to satisfy debts of the debtor, but they serve the important purpose of protecting the debtor’s essential needs, ensuring that the debtor is able to meet basic needs and have a fresh start after bankruptcy.
The exemption for assets held in Traditional and Roth IRAs is consistent with the purpose of the Bankruptcy Code’s provision. It ensures that debtors will be able to meet their basic needs during retirement years. And, the 10 percent early distribution penalty tax serves as a disincentive for the debtor to use those assets prior to reaching retirement age.
The Court noted that this is not the case with an inherited IRA. While a debtor might use the inherited IRA assets to meet their basic needs in retirement, if allowed to exempt them from the bankruptcy estate, there is nothing to prevent the debtor from using the assets for current consumption once the bankruptcy proceedings are complete. This would run contrary to the purpose of the Bankruptcy Code’s exemption provision and instead would provide a financial windfall for the debtor.
In affirming the judgment of the Seventh Circuit Court, the Supreme Court leaves inherited IRAs open to creditor claims in bankruptcy. It does not, however, preempt state statutes that exempt inherited IRAs in bankruptcy, or prevent states from adopting their own bankruptcy exemption for inherited IRAs. Under federal bankruptcy laws, states have the ability to opt in or opt out of the federal bankruptcy exemption scheme.
The Court’s ruling leaves a number of unanswered questions, including whether funds in a decedent’s 401(k) plan are entitled to bankruptcy protection.
In light of the Court’s decision, IRA owners may want to consider naming a trust—rather than an individual—as the beneficiary of their IRAs because a trust may offer greater asset protection to their beneficiaries. And, beneficiaries with creditor problems at the time of the IRA owner’s death should seek competent legal and tax advice to protect the IRA assets from creditor claims.
The Bankruptcy Code is very complicated and subject to local rules and judicial interpretation. Credit unions should direct members with specific questions regarding the recent Court ruling to seek competent legal and tax advice.
