Last week, in Clark et ux v. Rameker, Trustee, et al., the United States Supreme Court ruled that funds held in inherited IRAs do not fall within the meaning of the bankruptcy code's exemption for "retirement funds". Consequently, these funds may be available for distribution to creditors in bankruptcy.
Ruth Heffron established a traditional IRA and named her daughter, Heidi Heffron-Clark, as the sole beneficiary. When Ruth died, her IRA passed to Heidi and became an inherited IRA. Some years later, with the inherited IRA worth $300,000, Heidi and her husband filed a Chapter 7 bankruptcy petition. In their filing, they claimed that the inherited IRA qualified as a "retirement fund" within the meaning of the Bankruptcy Code, and claimed it as exempt from the bankruptcy estate and not available to their creditors.
The Supreme Court disagreed with the Clarks. The Court noted that because the Bankruptcy Code did not define the term "retirement funds", the Court needed to look at the ordinary meaning of that term to determine if the exemption applied to an inherited IRA. The Court said that "retirement funds" are sums of money set aside for the day when an individual stops working. In light of this definition, the Court provided three reasons why an inherited IRA does not constitute funds set aside for retirement:
- The holder of an inherited IRA is not permitted to invest additional money in the account. This is unlike traditional and Roth IRAs.
- The holder of an inherited IRA is required to take annual distributions regardless of how many years from retirement the holder might be.
- The holder of an inherited IRA may withdraw the entire balance of the account at any time, and for any purpose, without penalty. In contrast, a withdrawal from a traditional or Roth IRA prior to age 59 1/2 triggers a 10% penalty, unless an exception applies.
The Supreme Court's decision in Clark resolves a conflict among federal courts about the treatment of inherited IRAs under the Bankruptcy Code, but it doesn't resolve all questions about whether inherited IRAs are protected from creditors. The laws of each state law also provide individuals with protection from creditors. These state laws apply in bankruptcy cases when the debtor elects to avail himself of state law exemptions, instead of those available under the Bankruptcy Code. State laws also controls when a person has not filed for bankruptcy protection. For example, Pennsylvania law provides its own exemption from creditors for "retirement funds and accounts". To date, no Pennsylvania court has determined whether inherited IRAs fall within this definition, so we don't know whether Pennsylvania courts will adopt the rationale of the Supreme Court.
The Supreme Court's ruling is important because it reminds us that the creditor protection features of all IRAs aren't the same. As a result, other planning options should be considered. For example, if asset protection is the goal for the beneficiary of an inherited IRA, withdrawing funds from the IRA and investing them in an asset with greater asset protection certainty may be worth the associated income tax cost. Or, if the owner of a traditional or Roth IRA wants continued asset protection for her beneficiaries, maybe designating a trust as the account beneficiary rather than an individual is the way to achieve this goal.
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