June 23, 2014
Authored by: Stephanie Moll and Kathy Sherby
On June 12, the United States Supreme Court in Clark v Rameker resolved the question that has recently split the 5th and 7th Circuits— Are inherited IRAs protected from the beneficiary’s creditors in a bankruptcy proceeding? The Court unanimously held that they are not.
An inherited IRA is a traditional or Roth IRA that has been inherited by a beneficiary after the death of the owner. This term does not include an IRA that has been “rolled over” by a spouse beneficiary into her own IRA.
In order to make their decision, the Court had to determine whether an inherited IRA constitutes “retirement funds”, which are exempt assets in a bankruptcy estate.
The Court focused on three legal characteristics of inherited IRAs that led to their conclusion that the assets in an inherited IRA are not objectively set aside for the purpose of retirement:
1. The holder of the inherited IRA may not add assets to the account. On the other hand, traditional and Roth IRAs are designed to encourage contributions (contributions to traditional IRAs are tax-deductible and qualified distributions from Roth IRAs are tax-free).
2. Holders of inherited IRAs are required to take distributions, regardless of their age and retirement status–either within a five-year period after the owner’s death or in annual payments.
3. The holder of an inherited IRA can choose to withdraw all of the assets in the account at any time, without penalty.
Contrary to points 2 and 3, traditional and Roth IRAs discourage early withdrawals by imposing a 10 percent penalty on withdrawals before age 59 1/2.
The Court also reflected on the legislative intent of protecting retirement funds in bankruptcy–to provide a debtor with the basic necessities of life so that he will not become destitute and reliant on the government to survive. If an inherited IRA was protected in bankruptcy, there is nothing that would prevent the holder from withdrawing all of the assets immediately after the bankruptcy, resulting in a cash windfall or “free pass”.
This ruling potentially reinforces a decision to name a person’s revocable trust as the contingent beneficiary (after the owner’s spouse) on the owner’s death, rather than one or more individuals. By keeping the retirement plan in trust for future beneficiaries, the revocable trust (which becomes irrevocable upon the owner’s death) provides a different creditor protection than the bankruptcy exemption for retirement assets. But note, trusts must be carefully drafted to qualify as an “identifiable person” for purposes of delaying distributions over the beneficiary(ies)’s lifetime–make sure to consult your attorney to ensure your documents are properly crafted.