Certain Inherited IRA Accounts are NOT Exempt in Bankruptcy

Posted on Friday, July 11th, 2014

The title of this post is essentially the holding of the Supreme Court of the United States in Clark v. Rameker, 573 U.S. ____ (2014). Many debtors qualify to exempt certain “retirement funds” in a bankruptcy filing/case. However, in Clark the Supreme Court held that inherited IRA accounts, what most people would still consider “retirement funds,” are not exempt under 11 U.S.C. § 522(b)(3)(C).

The story: Ms. Heffron-Clark inherited IRA funds from her mother in 2001. In 2010 Ms. Heffron-Clark and her husband filed chapter 7 bankruptcy and listed the inherited IRA account as exempt from the bankruptcy estate under 11 U.S.C. § 522(b)(3)(C), which provides an exemption for “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation” under various provisions of the Internal Revenue Code of 1986. The Chapter 7 trustee objected to the exemption and the Wisconsin bankruptcy court denied the exemption. The U.S. district court reversed the bankruptcy court. The Seventh Circuit Court of Appeals reversed the district court. The Supreme Court of the United States granted certiorari (i.e. decided to review the matter) to resolve a circuit split (i.e. conflicting opinions) among the Seventh Circuit and the Fifth Circuit’s holding in In re Chilton, 674 F.3d 486 (5th Cir. 2012).

The rationale: SCOTUS, in the unanimous Clark decision, defined retirement funds as “sums of money set aside for the day an individual stops working.” SCOTUS looked to the legal characteristics of the inherited IRA account in Clark to determine if the account “is one set aside for the day when an individual stops working.” The Court held that the account was not set aside for the purpose of retirement, for three primary reasons:

  1. The holder of an inherited IRA account may never invest additional money into the account;
  2. The holder of an inherited IRA account is required to withdraw money from such accounts (often before retirement age); and
  3. The holder of an inherited IRA account may withdraw the entire balance of the account at any time without penalty. In the Court’s words: “Funds held in inherited IRAs accordingly constitute ‘a pot of money that can be freely used for current consumption,’ not funds objectively set aside for one’s retirement.” (citations omitted)

Going forward:

  1. The holding of Clark does not say that inherited IRA accounts can never be considered exempt because debtors in certain states can use state law exemptions. Therefore, if a state allows for exemption of inherited IRA accounts, a debtor may claim such funds as exempt under state law using 11 U.S.C. § 522(b)(3)(A), and the Clark decision does not prohibit that option.
  2. If your children are beneficiaries of IRA accounts, or if you have other beneficaries to an IRA account, you should reconsider the beneficiary designation and consider various trust arrangements that will avoid the result in Clark (i.e. an inherited IRA account being used to pay creditors instead of beneficiaries living expenses).