Thursday, June 12, 2014
Today, the Supreme Court issued a holding that says inherited IRAs are not protected in Bankruptcy. In Clark v. Rameker, petitioners filed for Chapter 7 bankruptcy, but sought to exclude approximately $300,000 in an inherited IRA from the bankruptcy estate using the “retirement funds” exemption. (See 11 U.S.C. § 522(b)(3)(C)). The Bankruptcy Court ruled that an inherited IRA does not share the same characteristics as a traditional IRA and disallowed the exemption. While the District court reversed, the Seventh Circuit reversed the District Court. The Supreme Court granted certiorari.
In holding that IRAs are not “retirement funds,” the Court explained that inherited IRAs do not operate like ordinary IRAs. Unlike a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. The owner of an inherited IRA must withdraw its funds; either by withdrawing the account balance within five years of the original owner’s death or by taking minimum distributions on an annual basis. Unlike a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.
Whether the given funds fall within “retirement funds,” is an objective inquiry. The Court looks to the legal characteristics of the account in which the funds are held, asking whether the account is one set aside for the day when an individual stops working. Various distinctions of inherited IRAs led the Court to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement.
This decision most notably has two important ramifications for spouses. A spouse who inherits has the ability to roll the assets into her own IRA and postpone distributions from a traditional IRA until she turns 70 ½. Yet, like other IRA owners, she may have to pay a 10% early-withdrawal penalty if she takes money before age 59 ½ from her own IRA. If the spouse chooses not to rollover, the account is considered an inherited IRA and under today’s decision those assets would not be protected in bankruptcy. Thus, spouses have one more reason to do a rollover.