Bankruptcy and Inherited IRAs

An inherited IRA has been generally regarded as a great way to fund retirement for a child or a grandchild.  Perhaps the original owner did not need to spend down the account, or died before exhausting it.  That premise has come under attack.  The Administration’s 2013 and 2014 budgets have proposed to have non-spousal inherited IRAs pay out in five years, rather than being stretched out for the lifetime of the beneficiary.  Now the Supreme Court has done its work with its decision in Clark v. Rameker, a dispute over an inherited IRA and the bankruptcy of a small-town pizza shop owner in Wisconsin.

In a unanimous opinion written by Justice Sonia Sotomayor, the U.S. Supreme Court held on June 15, 2014 held that funds from an inherited IRA were not retirement funds exempt from the debtor’s bankruptcy estate.

A revision of the federal bankruptcy law in 2005 protects retirement accounts from the reach of creditors. Heidi Heffron-Clark and her husband, Brandon Clark, declared bankruptcy in 2010 after their pizza shop closed. The Clarks' main asset was about $300,000 in an IRA inherited from Heffron-Clark's mother.

William Rameker, the trustee administering the Clarks' bankruptcy estate, wanted to get at the inherited IRA for the benefit of landlords and other creditors owed about $700,000.  The taxpayers sought to exclude the inherited IRA from the bankruptcy estate on the grounds that the money was “retirement funds” under the relevant section of the Bankruptcy Code that excludes retirement funds from a bankruptcy estate to the extent those funds are in a fund or account that is exempt from taxation under the IRS tax code

 In its unanimous decision, the Supreme Court explained that inherited IRAs are exempt from taxation under those sections of the tax code, they are not really retirement accounts because they differ from retirement accounts in three ways:

  • inherited IRA owners may not make additional contributions to the account;
  • owners must withdraw funds from their accounts, regardless of how many years they are from retirement;
  • owners are not subject to any age-related penalties for withdrawals from their accounts.

Taking all of these characteristics together, the Supreme Court determined that “[f]unds held in inherited IRAs accordingly constitute ‘a pot of money that can be freely used for current consumption,’ ... not funds objectively set aside for one’s retirement”.

There are at least two ways around this decision.  The first is to create an IRA trust where specific beneficiaries are identified within the trust, as the mechanism to direct an inherited IRA to its beneficiary.  The trust, and not the individual, is the beneficiary of the IRA, thus achieving protection from the Supreme Court decision in Clark.  IRA trusts have become increasingly popular as IRA and other retirement accounts have grown in size in the absence of a defined benefit (“pension”) retirement plans. 

The other way around is the application of state law.  Numerous states specifically exempt inherited IRAs from bankruptcy seizure.  While bankruptcy laws are federal laws, state laws can determine what assets of a debtor are exempt from seizure by a bankruptcy trustee.  If a state “opts out” of the federal definition of what is or is not exempt in bankruptcy, the state rules.  Virginia has opted out of the federal definition.  Of course, beneficiaries may not live in an “opt-out” state so relying on the laws in the state of residence of the creator of the IRA may not offer the necessary protection.

Law Office of Eileen Guerin Swicker