Inherited IRAs are not exempt in Chapter 7 bankruptcy
During bankruptcy, the assets of the debtor are placed in a bankruptcy estate, which is used to pay back creditors. In order to allow for the debtor to have a fresh start with the ability to provide for his or her basic needs without becoming a dependent of the state, the bankruptcy code allows debtors to withdraw or “exempt” certain assets from the bankruptcy estate to save for their own use. Included in the code at 11 USC § 522(b)(3)(C) are exemptions for retirement funds, including traditional IRAs and Roth IRAs, that meet certain standards. In Clark v. Rameker, the United States Supreme Court determined that the exemption does not apply to an inherited IRA. 13-299, 2014 WL 2608860, 2014 U.S. LEXIS 4166 (U.S. June 12, 2014).
Traditional and Roth IRAs provide tax advantages to individuals to encourage them to save for retirement. In addition, to ensure the funds are used for retirement purposes, restrictions are placed on the funds and a 10% penalty is assessed if a withdrawal is taken before the individual is 59.5 years old. When the owner of a traditional or Roth IRA dies, the account is transferred to an heir. If the heir is the owner’s spouse, the heir may choose to roll over the funds into their own IRA account or keep the account separate as an inherited IRA. All other heirs must keep the account separate as an inherited IRA. Heirs may not contribute to an inherited IRA account and must either withdraw the full balance within five years of inheritance or take annual distributions until the account is depleted.
Ruth Heffron established a traditional IRA in 2000, and the account was worth $450,000 at the time of her death in 2001. The account passed to her daughter Heidi Heffron-Clark, who elected to keep the account as an inherited IRA and receive distributions from the account. The daughter & her husband filed a Chapter 7 bankruptcy petition in October 2010 listing the inherited IRA, then worth $300,000, as exempt under the 11 U.S.C. § 522(b)(3)(C) retirement fund exemption. The bankruptcy court disallowed the exemption finding that due to the owner’s death, the funds were not retirement funds since they were not for anyone’s retirement. The decision was reversed at both the district and circuit level and was appealed to the Supreme Court.
The Supreme Court focused on the language of the exemption: “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue code of 1986.” 15 USC § 522(b)(3)(C). Using the plain meaning of the words, the Court found that retirement funds are “sums of money set aside for the day an individual stops working.” The Court found that the purpose of this exemption was to permit debtors to save money for retirement and not to allow for immediate spending by the debtor and for the exemption to apply the account must be both retirement funds and exempt from taxation.
In applying this standard to the inherited IRA, the Court found three significant differences between an inherited IRA and a traditional or Roth IRA. First, unlike retirement funds which encourage saving for retirement, the current owner is not permitted to contribute any funds to an inherited IRA. Second, inherited IRAs require the owner to withdraw funds either in a lump sum or annually regardless of the owner’s retirement status. Finally, the owner is permitted to withdraw all funds in an inherited IRA for any purpose, without restriction or penalty. This represented a significant departure from the plain meaning of the term retirement funds and the Court found it did not apply to an inherited IRA.
Even though the funds were initially contributed as retirement funds, the Court focused on the current status of the funds, finding that the above differences changed the status of the funds to non-retirement. The Court also rejected the debtor’s argument that the funds should be exempted as they remained exempt from taxes under the Internal Revenue Code. The Court found that the language of the exemption requires that the funds be both retirement funds and exempt from taxation, with inherited IRAs only satisfying the taxation requirement.
As inherited IRAs don’t fit within the definition of retirement funds and their exemption from the bankruptcy estate doesn’t serve the purposes of the bankruptcy code, the Court found that inherited IRAs are not exempt in a Chapter 7 bankruptcy.
** Many thanks to William Abbey for his contributions to this article. William is a law clerk with Slovin & Associates Co., L.P.A. and student at the University of Cincinnati College of Law. **