In April, the Seventh Circuit Court of Appeals split with the Fifth Circuit – and other lower courts – on an issue at the intersection of bankruptcy and trusts and estate law. In In re Clark, 714 F.3d 559 (7th Cir. 2013), the court held that funds in an individual retirement account inherited from someone other than the bankrupt debtor’s spouse are not “retirement funds” within the meaning of the United States Bankruptcy Code and are, therefore, available to pay creditors of the debtor-heir. The various courts that have addressed the issue have gone in both directions and now the United States Supreme Court has spoken.
The U.S. Supreme Court has now weighed in, and has ruled that inherited IRAs are not exempt from bankruptcy creditor claims. The Court analyzed the issue as to whether inherited IRAs are enough like regular retirement assets (i.e., sums set aside until one stops working) to be entitled to the standard IRA exemption. It did so in an attempt to balance the interests of creditors and debtors, by giving only protection to those accounts that have enough “retirement fund” characteristics.
The Court found that certain key aspects of inherited IRAs are not like a retirement asset. In particular, the Court noted (a) inherited IRA holders cannot add new assets, (b) required distributions did not turn on whether the holder has reached retirement age, and (c) holders can withdraw from the IRA without penalty at any time. Thus, it is improper to allow an exemption.
Indeed, an original IRA account holder may not withdraw funds before age 59 without paying a steep penalty. In contrast, an inherited IRA is treated in exactly the opposite way, with withdrawals mandated annually.
Those states who opt out of the Bankruptcy Code exemptions in favor of their own exemptions, may still have an exemption for inherited IRAs. This is because the decision in Clark only addressed the federal exemptions applicable in non-opt out states. Debtors in those states providing explicit protection to an inherited IRA should be unaffected by Clark and thus their inherited IRAs should still be protected.
This does not mean inherited IRA benefits cannot be protected against creditors of the recipient. Through the use of trusts and applicable spendthrift and other trust protections that exist under applicable state law, inherited IRA proceeds can be protected by leaving them to trusts instead of outright to the recipients. Of course, planning for such trusts will need to coordinate with the IRA rules for allowance of deferral of required distributions, to the extent such deferral is desirable or otherwise available.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. *Randall A. Denha, JD, LL.M., is the Principal and Founder of the law firm of Denha & Associates, PLLC with offices in Birmingham, MI and West Bloomfield, MI. Mr. Denha continues to be recognized as a “Super Lawyer” by Michigan Super Lawyers in the areas of Trusts and Estates; a “Top Lawyer” by D Business Magazine in the areas of Estate Planning and Tax Law; a Five Star Wealth Planning Professional and a New York Times Top Attorney in Michigan. Mr. Denha can be reached at 248-265-4100 or by email at firstname.lastname@example.org