Inherited IRA’s Not Entitled to Bankruptcy Protection

Posted on June 30, 2014

There are several types of IRA accounts: In a traditional IRA, contributions are made on a pre-tax basis. In a Roth IRA contributions are made on an after-tax basis but qualified distributions from the account are tax-free. A third type of account is an inherited IRA.

An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death.  If the heir is the owner’s spouse, the spouse may “roll over” the IRA funds into his or her own IRA or keep the IRA as an “inherited IRA.” When anyone other than the owner’s spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account.  Unlike a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. In fact, the owner  must  either  withdraw  the entire  balance  in  the  account  within  five  years  of  the original owner’s death or take minimum distributions on an annual basis. Moreover, the owner of an inherited IRA may never make contributions to the account

The bankruptcy law excludes IRA accounts from the bankruptcy estate subject to creditor claims if the funds are “retirement funds.” Over the years, the federal courts have reached different conclusions as to whether inherited IRA’s are retirement funds exempt from the claims of creditors.

The United States Supreme Court agreed to hear the case of Clark v. Rameker, to resolve the conflict in the lower courts. In a unanimous opinion the Court held that funds from an inherited IRA were not retirement funds that were exempt from the debtor’s bankruptcy estate.

The taxpayers in the case filed for Chapter 7 bankruptcy and sought to exclude approximately $300,000 in an inherited IRA from the bankruptcy estate on the grounds that the money was “retirement funds” protected under the Bankruptcy Code exemption discussed above. The Court explained, although traditional retirement accounts, such as IRAs or Roth IRAs, are included in this definition, inherited IRAs are not because they do not operate as retirement accounts.

The Supreme Court pointed to three legal characteristics of inherited IRAs that led it to conclude they are not retirement accounts. First, inherited IRA owners may not make additional contributions to the account. Second, owners must withdraw funds from their accounts, regardless of how many years they are from retirement. Third, owners are not subject to any age-related penalties for withdrawals from their accounts. Taking all of these characteristics together, the Court concluded that the funds in the account can be freely used for current consumption and are not set aside for one’s retirement.

According to the Court, allowing bankruptcy exemptions for funds that are not restricted to use for retirement, as inherited IRAs are not, would allow debtors to use those funds for current consumption after bankruptcy proceedings are complete, would subvert the purpose of the bankruptcy law to give the debtor a “fresh start’ by making it  a ‘free pass.” (Citations omitted.)

While the Court’s decision is the final word on this issue, this case dealt with a beneficiary who was the child of the IRA owner and Court did not discuss the case where the beneficiary is the account owner’s spouse. As indicated above if the beneficiary is the account owner’s spouse different rules apply. The spouse has the option to roll the funds into his/her own IRA or designate the deceased owner’s IRA as his/her own. Making either of these elections will free the account from inherited IRA restrictions so presumably these assets will continue to have bankruptcy protection. However, if the spouse opts not to make either of these elections it becomes an inherited IRA and loses the protection under the bankruptcy law. This is a trap for an unwary spouse.

Would the Court reach a different conclusion for an inherited IRA of a spouse? Certainly, the funds that were being saved for retirement were for the benefit of both spouses. While it is questionable whether the Court would reach a different conclusion, a stronger case can be made that bankruptcy protection for the account owner’s spouse should continue.

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