On June 12, 2014, the Supreme Court unanimously upheld a Seventh Circuit decision that said inherited IRAs do not enjoy the protections of IRAs in bankruptcy proceedings.
The petitioner in Clark v. Rameker, Trustee, Hedi Heffron-Clark, inherited an IRA worth about $300,000 in 2001. In October 2010, the Clarks filed voluntary joint bankruptcy and claimed an inherited IRA under the Section 522 exemption, to which the bankruptcy trustee and creditors objected. The district court ruled that inherited IRAs are exempt because they retain their character as retirement funds, but the U.S. Court of Appeals for the Seventh Circuit reversed that ruling.
In 2005 President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). While, on the whole, the law was designed to make filing for bankruptcy less appealing, it had a silver lining for retirement account owners. BAPCPA afforded a great deal of bankruptcy protection to “retirement funds,” providing IRAs and Roth IRAs with a cumulative $1 million inflation-adjusted (currently $1,245,475) exemption and employer-sponsored plans with an unlimited exemption. As a result, the term “retirement funds” became subject to varies form of interpretation. Bankruptcy trustees eventually began to challenge the exempt status of inherited IRAs, citing that they weren’t “retirement funds” and thus, not protected in bankruptcy under the federal bankruptcy rules. For the past few years, various courts have weighed in on the issue, delivering anything but consistent decisions.
Tax law treats IRAs inherited from a non-spouse (“Inherited IRAs”) differently from IRAs bequeathed by a spouse; for example:
- the survivor-beneficiary may not treat the Inherited IRA as his or her own and may not roll the inherited funds over into his or her own IRA (as a beneficiary-spouse may);
- the Inherited IRA must be set up in the deceased owner’s own name, for the benefit of the non-spouse beneficiary;
- the beneficiary may not add contributions of his or her own funds to the Inherited IRA; and
- the beneficiary must take distributions immediately from the Inherited IRA (either in a lump or over time), regardless of the beneficiary’s age or employment status.
In the unanimous opinion written by Justice Sonia Sotomayor, the Supreme Court agreed with the Seventh Circuit: “the possibility that some investors may use their inherited IRAs for retirement purposes does not mean that inherited IRAs bear the defining legal characteristics of retirement funds. Were it any other way, money in an ordinary checking account (or, for that matter, an envelope of $20 bills) would also amount to “retirement funds” because it is possible for an owner to use those funds for retirement.”
When Heidi Heffron-Clark declared bankruptcy in October 2010, she and her husband claimed the IRA she inherited from her mother — then worth $300,000 — qualified as “retirement funds,” meaning the couple could not be required to use it to pay debts they owed creditors.
Heffron-Clark, now 35, never contributed to the IRA; she had already drawn $150,000 in monthly payouts from the account since her mother’s death in 2001. She could also withdraw the entire amount of the IRA any time, without penalty. The bankruptcy court ruled against Heffron-Clark, declaring that an inherited IRA represented “an opportunity for current consumption, not a fund of retirement savings.” The Supreme Court agreed unanimously.
The Court’s analysis turned on key legal distinctions between inherited IRAs which one inherited from a non-spouse and an IRA that you set up and fund yourself, either through annual contributions or by rolling over assets from a company plan.
Several features make inherited IRAs unique and suggest that they are not retirement assets, the Court noted. Unlike IRA owners, inheritors can’t put additional funds into the account, and they can take out money at any time without penalty. In fact, generally, non-spousal IRA heirs must either withdraw the entire account balance within five years of the original owner’s death, or take out a calculated minimum amount each year, starting by Dec. 31 of the year after the IRA owner died.
Does this decision apply to all inherited IRAs?
Although the Supreme Court’s decision doesn’t explicitly state one way or another, its ruling seems to be limited to IRAs inherited by someone other than a spouse. There are a number of special rules for spousal beneficiaries under the tax code, including the ability for a surviving spouse to rollover a decedent’s IRA into their own IRA. In fact, during oral arguments, the bankruptcy trustee’s attorney even made a point to distinguish Clark’s inherited IRA from that of a surviving spouse.
The ruling will likely impact a considerable segment of the population who have inherited IRAs from a non-spouse and will certainly change the way asset protection and estate planning is conducted in these cases.