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 Bankruptcy Code Meets the Internal Revenue Code – and the IRC Wins
Individuals declare bankruptcy to obtain a “fresh start,” free of onerous financial obligations. Because people need resources with which to start over, the Bankruptcy Code permits debtors to withhold from their creditors an array of property, including “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Section . . . 408 . . . of the Internal Revenue Code of 1986 [IRC].” IRC §408 creates the tax exemption for individual retirement accounts (IRAs). The general rule, then, is that a debtor’s own IRA is completely exempt from creditor claims in bankruptcy, no matter how much cash may have accumulated in that IRA. Moreover, IRAs inherited from a deceased spouse may also become fully exempt in the surviving spouse’s bankruptcy.
The issue in Clark, however, was whether $300,000 in a mother’s IRA was entitled to be fully exempted in the bankruptcy case of her daughter, who had inherited the IRA upon her mother’s death. Tax law treats IRAs inherited from a non-spouse (“Inherited IRAs”) differently from IRAs bequeathed by a spouse; for example:
- the survivor-beneficiary may not treat the Inherited IRA as his or her own and may not roll the inherited funds over into his or her own IRA (as a beneficiary-spouse may);
- the Inherited IRA must be set up in the deceased owner’s own name, for the benefit of the non-spouse beneficiary;
- the beneficiary may not add contributions of his or her own funds to the Inherited IRA; and
- the beneficiary must take distributions immediately from the Inherited IRA (either in a lump or over time), regardless of the beneficiary’s age or employment status.
The Circuits Split Over the Phrase “Retirement Funds”
Two federal courts of appeal – here, the Fifth and Seventh Circuits – whose decisions are binding in the regions that they cover – have come to opposite conclusions, while construing the meaning of the same term.
Last year, the Fifth Circuit decided that the phrase “retirement funds” in the bankruptcy exemption statute quoted above means any funds “set apart” in anticipation of “withdrawal from office, active service, or business” and that the statute does not limit “retirement funds” solely to funds of the bankrupt debtor, so long as the funds were originally “set apart” for someone's retirement. In re Chilton, 674 F.3d 486 (5th Cir. 2012). Once set apart as retirement funds, they would maintain that same character for bankruptcy exemption purposes. The court, therefore, permitted the debtor in Chilton to exempt all of a $170,000 IRA inherited from her mother.
In Clark, the Seventh Circuit expressly disagreed with the Fifth Circuit, adding that it “do[es] not think the question is close.” The Seventh Circuit observed that, while Inherited IRAs do shelter money from taxes until it is withdrawn, they lack many of the other attributes of a retirement account. The court noted in particular that the beneficiary of an Inherited IRA is prohibited from rolling those funds over into her own IRA and from adding her own funds to the Inherited IRA. The beneficiary must take distributions from the Inherited IRA within a year of the original owner’s death and complete those payouts over a defined period, often as little as five years, whatever the beneficiary’s age and whatever her employment status. In short, once the original owned died, “the money in the [I]nherited IRA did not represent anyone’s retirement funds.” (Emphasis in original.)
The Seventh Circuit drew an analogy to the homestead exemption. The court noted that the mother might have been entitled to exempt her primary residence as a homestead in her own bankruptcy case. However, if her daughter had inherited her mother’s house and rented it out, the building would have lost its character as a homestead and could not have been so exempted in the daughter’s bankruptcy. Similarly, the mother’s IRA money lost its character as retirement funds when the mother died; her daughter could not then use that money as her own retirement savings, and it became no different from an inherited certificate of deposit or money market account: non-exempt and available to distribute to the daughter’s creditors.
The Clark decision, the first of its kind at the appellate level, creates a new risk – at least in the states of Illinois, Indiana, and Wisconsin covered by the decision – that IRA money left to heirs will not be protected from creditors if those heirs endure serious financial setbacks. Yet for those living in the states covered by the Chilton decision – Texas, Louisiana, Mississippi – Inherited IRAs are exempt in bankruptcy. Until the United States Supreme Court resolves this conflict, where a person lives may be the determining factor as to whether an Inherited IRA is exempt in that person’s bankruptcy case. Insolvency and estate planning counsel can help you understand and plan for this new risk.