Supreme Court Affirms That Inherited IRAs Are Not Exempt from Bankruptcy Estate.
(Parker Tax Publishing June 25, 2014)

Last week, the Supreme Court settled an enduring dispute about whether or not a debtor is entitled to shield an inherited IRA from a bankruptcy estate. In the case at issue, a woman had inherited an IRA from her mother. Nine years later, the woman filed for bankruptcy and sought to exempt the inherited IRA from the bankruptcy estate by using the retirement funds exemption in Bankruptcy Code Section 522(b)(3)(C). A bankruptcy court concluded that an inherited IRA does not share the same characteristics as a traditional IRA and disallowed the exemption. A district court reversed, explaining that the exemption covers any account in which the funds were originally accumulated for retirement purposes. The Seventh Circuit disagreed and reversed the district court. In Clark v. Rameker, 2014 PTC 277 (S. Ct. 6/12/14), the Supreme Court unanimously agreed with the Seventh Circuit and held that the taxpayer could not exempt her inherited IRA from the bankruptcy estate. In so holding, the Court drew a distinction between traditional and Roth IRAs, which are protected from a bankruptcy estate, and inherited IRAs, which are not.

Practice Tip:As discussed below, if the taxpayer had inherited the IRA from a spouse, she would have had the option to roll over the IRA funds into a traditional IRA, which would have protected the amounts from the bankruptcy estate. However, the option to roll over an inherited IRA to a traditional IRA needs to be weighed against the possible detriments of such action. For example, certain distributions before age 59 and 1/2 years old are subject to the 10 percent penalty tax on early withdrawals, whereas such distributions from an inherited IRA are not.

Background

In 2000, Ruth Heffron established a traditional IRA and named her daughter, Heidi, as the sole beneficiary of the account. When Ms. Heffron died in 2001, her IRA which was then worth just over $450,000 passed to Heidi and became an inherited IRA. Heidi elected to take monthly distributions from the account. In October 2010, Heidi and her husband filed for Chapter 7 bankruptcy. They identified the inherited IRA, by then worth roughly $300,000, as exempt from the bankruptcy estate under Bankruptcy Code Section 522(b)(3)(C). The bankruptcy trustee and unsecured creditors of the estate objected to the claimed exemption on the ground that the funds in the inherited IRA were not "retirement funds" within the meaning of the statute.

Bankruptcy and the IRA Exemption

When an individual debtor files a bankruptcy petition, the debtor's legal or equitable interests in property become part of the bankruptcy estate. To help the debtor obtain a fresh start, however, the Bankruptcy Code allows debtors to exempt from the bankruptcy estate limited interests in certain kinds of property. Bankruptcy Code Section 522(b)(3)(C) and (d)(12) allow debtors to protect retirement funds to the extent those funds are in a fund or account that is exempt from tax under Code Secs. 401, 403, 408, 408A, 414, 457, or 501(a). These provisions cover many types of accounts, three of which were relevant in the instant case.

The first two are traditional and Roth IRAs, which are covered by Code Sec. 408 and Code Sec. 408A, respectively. Both types of accounts offer tax advantages to encourage individuals to save for retirement. Qualified contributions to traditional IRAs, for example, are tax-deductible. Roth IRAs offer the opposite benefit although contributions are not tax deductible, qualified distributions are tax free. To ensure that both types of IRAs are used for retirement purposes and not as general tax-advantaged savings vehicles, certain withdrawals from both types of accounts are subject to a 10 percent penalty if taken before an accountholder reaches age 59 and 1/2.

The third type of account, as at issue in the instant case, is an inherited IRA. An inherited IRA is a traditional or Roth IRA that has been inherited after its owner's death. If the heir is the owner's spouse, as is often the case, the spouse has a choice. The spouse may "roll over" the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA, subject to certain requirements. When anyone other than the owner's spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account.

Importantly, inherited IRAs do not operate like ordinary IRAs. Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. In fact, the owner of an inherited IRA not only may, but must withdraw its funds; the owner must either withdraw the entire balance in the account within five years of the original owner's death or take minimum distributions on an annual basis. And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.

Taxpayer's Arguments

Heidi argued that funds in an inherited IRA are retirement funds regardless of whether they currently sit in an account bearing the legal characteristics of a fund set aside for retirement because they previously had when the initial owner of the account set aside the funds in question for retirement by depositing them in a traditional or Roth IRA. The initial owner's death, Heidi contended, does not in any way affect the funds in the account.

Supreme Court's Analysis

The Supreme Court held that funds in an inherited IRAs are not "retirement funds" within meaning of Bankruptcy Code Section 522(b)(3)(C). The ordinary meaning of "retirement funds," the Court stated, is properly defined as sums of money set aside for the day an individual stops working. According to the Court, three legal characteristics of inherited IRAs provide objective evidence that they are not "retirement funds" for the purposes of the Bankruptcy Code exception. First, Internal Revenue Code Sec. 219(d)(4) states the holder of an inherited IRA may never invest additional money in the account. Second, under Internal Revenue Code Sec. 408(a)(6) and Code Sec. 401(a)(9)(B), holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. Finally, the holder of an inherited IRA may withdraw the entire balance of the account at anytime and use it for any purpose without penalty.

The purpose of the Bankruptcy Code's retirement funds exemption provisions, the Court said, is to effectuate a careful balance between the creditor's interest in recovering assets and the debtor's interest in protecting essential needs. Allowing debtors to protect funds in traditional and Roth IRAs ensures that debtors will be able to meet their basic needs during their retirement years. By contrast, the Court observed, nothing about an inherited IRA's legal characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for current consumption. The retirement funds exemption should not be read in a manner that would convert the bankruptcy objective of protecting debtors' basic needs into a "free pass," the Court reasoned.

According to the Court, Heidi's arguments did not overcome the statute's text and purpose. The claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for retirement, conflicts with ordinary usage and would render the term "retirement funds," as used in Bankruptcy Code Section 522(b)(3)(C), superfluous. Congress could have achieved the exact same result, the Court noted, without specifying the funds as "retirement funds." (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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