In the recent case of Clark v. Rameker, 573 U.S. _____ (2014), the Supreme Court was tasked with determining whether the Federal Bankruptcy Code protects inherited IRAs in Bankruptcy against the claims of a bankruptcy debtor’s creditors.
Section 522(b)(3)(C) of the Bankruptcy code describes protected assets to include “retirement funds” that are “exempt from taxation” under IRC Code Sections 401, 403, 408, 408A, 414, 457, or 501(a). An account therefore, generally has to be characterized as a retirement vehicle in order to qualify as exempt under the Federal Bankruptcy Code.
In Clark, Ruth Heffron died, leaving her IRA to her daughter, Heidi, a Wisconsin resident. Heidi elected to receive the account as an inherited IRA and to take required minimum distributions over her remaining life expectancy, in accordance with the IRS Regulations. In 2010, Heidi and her husband filed for Chapter 7 bankruptcy, excluding the IRA from their bankruptcy estates. Heidi’s bankruptcy creditors argued that the IRA funds were improperly excluded from her bankruptcy estate because an inherited IRA is not a retirement fund under the definition of Section 522.
The Supreme Court agreed with the creditors, holding that assets held under an IRA inherited by a non-spouse beneficiary are not “retirement funds,” and are therefore not protected by bankruptcy creditors. The Court noted that material differences between an originally owned IRA and an inherited IRA reflect Congress’ intent that inherited IRAs are not “held for retirement”.
First, the Court reasoned that inherited IRA beneficiaries must take required minimum distributions on at least an annual basis, reducing the potential of the account as a retirement savings vehicle. The Internal Revenue Code requires that the beneficiary of an inherited IRA take required minimum distributions over their individual life expectancy, or within five years of the account owner’s death (depending upon whether the original owner passed away before or after attaining the age of 70 ½, respectively). This is in contrast to an original IRA, where the original account owner does not have to start taking distributions until the reach the age of 70 ½.
Second, the Court held that because an inherited IRA account beneficiary may never make contributions to the account, a beneficiary of a retirement account is therefore not incentivized to contribute to their retirement savings.
Finally, the Court reasoned that because inherited IRA beneficiaries may withdraw amounts from their account at any time penalty-free, they are not funds “objectively set aside for one’s retirement.” This is in contrast to an original IRA, where the owner is penalized from reducing their retirement savings if they make a withdrawal from their account prior to reaching the age of 59 ½.
The Supreme Court’s opinion did not make it entirely clear as to whether spousal rollovers would be definitively protected in bankruptcy. As there is no deadline for a surviving spouse to elect to perform a qualified rollover of their spouse’s IRA account, a surviving spouse could initially choose to accept an inherited IRA for immediate access to the funds and later rollover the account into his or her own IRA. Performing a spousal rollover soon before a bankruptcy filing could create an argument by a creditor that the rollover was effectively a “fraudulent transfer” that should be undone.
Additionally, it is important to understand the limitations of this holding to bankruptcy proceedings – and further, to those debtors that have opted to utilize the Federal bankruptcy exemption rules. Each state has its own bankruptcy exemptions, and five states exempt inherited IRAs from the claims of bankruptcy creditors. If a bankruptcy debtor has satisfied their states’ domicile requirements, they may opt into their state bankruptcy exemptions, which may be more favorable than the Federal ones.
Furthermore, many, if not the majority of states, exempt inherited IRAs from the claims of creditors outside of bankruptcy (with limited exceptions). Even so, when leaving retirement assets to a non-spouse beneficiary, one should consider designating a qualifying “see-through” trust as the designated beneficiary of an IRA account in order to achieve protection from claims of their beneficiaries’ known and unknown exception creditors as well as to achieve the desired income-tax deferral of extended required minimum distributions.
I expect that we will see more law further expounding upon some of these new and novel concepts in the near future.