The U.S. Supreme Court has held — in a unanimous decision — that inherited IRAs do not qualify for an exemption from the bankruptcy estate. Therefore, they are not protected from creditors in bankruptcy. The case, Clark v. Rameker, has significant implications for inherited IRAs.
Facts of the Case
In 2001, Heidi Heffron-Clark inherited her deceased mother’s traditional IRA, as sole beneficiary. The IRA was worth about $450,000, and Heidi and her husband Brandon elected to take monthly distributions from the IRA.
In 2010, the Clarks filed a bankruptcy petition under Chapter 7 of the Bankruptcy Code. In their petition, the Clarks sought to exempt the inherited IRA, now worth about $300,000, from their bankruptcy estate, under a provision of the Bankruptcy Code.
Under Bankruptcy Code Section 522(b)(3)(C), a debtor may exempt amounts that are:
- “Retirement funds,” and
- Exempt from income tax under one of several specified Internal Revenue Code provisions, including Code Section 408, which provides a tax exemption for IRAs.
Long Journey through the Courts
The bankruptcy trustee and the Clarks’ unsecured creditors objected, arguing that the funds held in the inherited IRA were not “retirement funds” within the meaning of the law, and so could not be exempted from the bankruptcy estate. The bankruptcy court agreed, finding that inherited IRAs don’t hold anyone’s retirement funds, because the funds are not set aside for retirement needs, nor are they distributed upon retirement.
The bankruptcy court’s decision was appealed to a federal district court, which reversed the bankruptcy court’s decision and held that the inherited IRA did qualify for the Bankruptcy Code exemption. This decision was again appealed, this time to the Seventh Circuit, which found that the bankruptcy court had gotten it right, and that the Clarks’ inherited IRA did not qualify for the Bankruptcy Code Section 522(b)(3)(C) exemption.
The Seventh Circuit’s decision was at odds with an earlier holding by the Fifth Circuit (Chilton v. Moser, CA5, 674 F3d 486, 5/1/2012) and so the Supreme Court agreed to hear the case to resolve the split in the circuit courts. Justice Sonia Sotomayor delivered the opinion for a unanimous court, stating that “text and purpose” of the Bankruptcy Code provided that funds held in inherited IRAs are not “retirement funds” for purposes of the Bankruptcy Code Section 522(b)(3)(C) exemption.
The Court began its review by noting that the Bankruptcy Code does not provide a definition of “retirement funds.” Using the ordinary meaning of the term, the Court stated that “retirement funds” refers to money that is set aside for the time that a person is no longer working. To determine if funds held in an account are “retirement funds,” the Court said that the determination should be based on the legal characteristics of the account holding the funds, and if the account is one that was set aside for when an individual is no longer working.
There are three legal characteristics of inherited IRAs that made funds held in these accounts not objectively set aside for the purpose of retirement, according to the Court.
First, said the Court, Code Sec. 219(d)(4) prevents holders of inherited IRAs from putting additional funds into the account. Thus, where traditional and Roth IRAs allow their account holders to add to their retirement savings over time, inherited IRAs prohibit contributions to the account.
Second, holders of inherited IRAs must withdraw money from such accounts, without regard to the number of years until the account holder reaches retirement. That the tax rules governing inherited IRAs require that the accounts be depleted over time, regardless of how close their holders are to retirement, said the Court, is not a feature of an account set aside for retirement.
Third, inherited IRA owners may make penalty-free withdraws from the account at any time, up to the entire balance of the account, without triggering the 10 percent early withdrawal penalty of Code Section 72(t). In contrast, the nation’s top Court stated withdrawals from a traditional or Roth IRA before the account holder reaches age 59 1/2 are subject to the early withdrawal penalty, unless one of several limited exceptions applies. Thus, funds held in inherited IRAs can be used for current consumption, while those in traditional and Roth IRAs cannot.
“Fresh Start” versus “Free Pass”
According to the Court, the exemptions provided by the Bankruptcy Code create a balance between the rights of creditors and the needs of debtors. Allowing debtors to protect funds held in traditional and Roth IRAs aligns with this balance by helping to ensure that debtors will be able to meet their basic needs during retirement. At the same time, the limits on traditional and Roth IRAs help make sure that the debtors who hold these accounts (but who have not yet reached age 59 1/2) do not enjoy a windfall due to the exemption.
In contrast, the Court stated that there are characteristics of an inherited IRA that would limit the account holder’s ability to use the entire account balance for purposes other than preparing for retirement once the bankruptcy proceedings are completed. Thus, allowing the exemption for inherited IRAs, said the Court, would turn the Bankruptcy Code’s “fresh start,” into a “free pass.”
Change in Fund Status
The Clarks further argued that, because the funds in an inherited IRA were once set aside for retirement of the initial IRA owner, the funds continued to have the legal characteristics of funds set aside for retirement even after the original owner’s death. That is, the death of the initial IRA holder would not in any way affect the funds in the account.
Calling this a “backward-looking inquiry,” the Court said that the ordinary use of the terms “retirement funds” implied that the funds were currently in an account set aside for retirement, not that they were set aside for retirement at some point in the past. Further, said the Court, the Bankruptcy Code Section 522(b)(3)(C) exemption has two requirements: that funds be retirement funds, and that the funds be held in a covered account. Thus, the Court dismissed this argument because it ignored the statute’s first requirement (that the funds be retirement funds).