On June 12, 2014, the U.S. Supreme Court unanimously held in Clark v. Ramekerthat an inherited individual retirement account (IRA) does not qualify for the “retirement funds” exemption in the Bankruptcy Code and is not excluded from a bankruptcy estate on that basis. That exemption protects “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code” (IRC). While an inherited IRA – i.e., an IRA that, on the original IRA owner’s death, passes either (i) to a spouse who elects not to roll over that account to his or her own IRA, or (ii) to a non-spouse beneficiary – is exempt from tax under section 408, the Court reasoned that it was not a “retirement fund” because under the IRC, and unlike other IRAs or Roth IRAs:
- New contributions can never be made to an inherited IRA;
- Withdrawals from an inherited IRA are never subject to the IRC § 72(t) premature distribution penalty tax and can be freely consumed at any time; and
- Distributions from an inherited IRA must either systematically commence within one year of the original owner’s death or be completed within five years of the date of the death, without regard to the new holder’s proximity to retirement.
For these reasons, the Court concluded that, objectively, inherited IRAs are not “retirement funds” in the ordinary sense of that term, i.e., funds set aside by the debtor/inherited IRA holder for the purpose of retirement. The Court further concluded that result was consistent with the purposes of the Bankruptcy Code and its balancing of the interests of creditors and debtors.
- The Court’s decision addresses a conflict between the U.S. Court of Appeals for the Fifth and Seventh Circuits on this issue.
- At least in some circumstances, the Clark decision will influence (i) IRA owners, in choosing whether to name a spouse, another person or, e.g., a spendthrift trust as beneficiary (a matter of some complexity), and (ii) spouses who inherit IRAs, in choosing whether to roll those funds to the spouse’s own IRA (a choice which also involves tax and other considerations).
- In addition, IRA providers should update their procedures and, if applicable, written IRA materials to reflect this distinction between inherited IRAs and other IRAs.
- Exemptions from a bankruptcy estate can be effected through state law as well as the Bankruptcy Code, and more states may now consider legislation to explicitly protect inherited IRAs.
- In a small break from tradition for Supreme Court cases related to retirement arrangements, the opinion was authored by the second-most junior justice in the majority (Justice Sonia Sotomayor) rather than the most junior justice (Justice Elena Kagan). Clark is the first such opinion for Justice Sotomayor.