Supreme Court Rules on Bankruptcy Protection of Inherited IRAs

Jun 30, 2014

The federal government and each state have a list of assets that are protected under the bankruptcy code. Every state protects personal residences. (Some states offer virtually unlimited protection and other states offer only protect a modest amount of equity in the home.) The amount of protection for qualified retirement plans governed by ERISA (Employee Retirement Income Security Act) and contributory IRAs is also defined by both federal bankruptcy law as well as state laws. An area of controversy has been how much, if any, bankruptcy protection should be afforded to inherited IRAs. An inherited IRA is an IRA received as the result of being a beneficiary of a decedent’s IRA (spouses can elect either to rollover the IRA into his or her own name or take the IRA as an inherited IRA).

Courts across the country have been divided on whether an inherited IRA should receive the same kind of protections as a contributory IRA. Until recently, the vast majority of the courts have ruled that inherited IRAs are not protected. In recent years there has been a shift in favor of debtors with inherited IRAs. The United States Supreme Court, in Clark, et ux. v. Rameker, 573 U.S. ___ (June 12, 2014), was asked to resolve the conflict in decisions from the Seventh Circuit Court of Appeals in In re Clark, 466 B.R. 135 (2012) (holding the inherited IRA was not protected in bankruptcy proceedings) and the Fifth Circuit Court of Appeals in In re Chilton, 674 F.3d 486 (2012) (holding an inherited IRA was protected).

In its decision, the Supreme Court stated that the ordinary meaning of “retirement funds” is properly understood to be sums of money set aside for the day an individual stops working. The court found the following characteristics of inherited IRAs show they are not retirement funds: (1) the holder of an inherited IRA may never invest additional money in the account, (2) holders of inherited IRAs are required to withdraw annual distributions even if he or she is continuing to work and is years away from actual retirement, and (3) the holder on an inherited IRA may withdraw the entire balance of the account anytime – and use it for any purpose – without penalty (although income taxes would need to be paid).

The Supreme Court reasoned that debtors should be able to protect funds in contributory IRAs (traditional and ROTH) because it assures he or she will be able to meet his or her basic needs during retirement years. The characteristics of an inherited IRA do not prevent or discourage the debtor from accessing the entire balance immediately after bankruptcy for purposes of current consumption. The court rejected the claim that funds in an inherited IRA are retirement funds because they were originally set aside for retirement by the original owner, who is now deceased.

Members of the American Academy of Estate Planning Attorneys have long promoted estate planning strategies using trusts to protect inherited IRA assets and allow distributions from the inherited IRA to be postponed for the longest time allowed under the Treasury Regulations. With the ruling in Clark, it is now clear that inherited IRAs not protected by a trust are not protected in the event of the bankruptcy of the debtor/beneficiary. If a parent or grandparent desires to protect an inherited IRA from the creditors of children and grandchildren, as well as the trustee in the bankruptcy court, he or she must create a special trust under Section 401(a)(9) of the Internal Revenue Code that is known as a qualified beneficiary trust. The qualified beneficiary trust can be created for a child, grandchild, or any other beneficiary of the inherited IRA. The retirement plan trusts can be drafted to offer varying levels of asset protection and flexibility, including complete protection from almost all creditors. Depending on the desires of the client, an estate planning attorney may draft these trusts as part of the revocable living trust of the client or as separate trusts for one or more beneficiaries.

Our office focuses on many areas of estate planning, including the complexity of planning for tax deferral and asset protection of an inherited IRA. We work with clients of all age, income, and wealth levels. As a member of the American Academy of Estate Planning Attorneys, our firm is kept up-to-date with information about recent developments, such as this Supreme Court case. You can get more information about scheduling a complimentary estate planning appointment and our planning and administration services by calling our office.

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