On June 12, 2014, the Supreme Court held that assets of an “inherited IRA” are not exempt from the IRA holder’s bankruptcy estate and are subject to the claims of creditors in bankruptcy. (Clark v. Rameker, Sup. Ct. Slip Op. No. 13-299, affirming In re Clark, 714 F.3d 559 (7th Cir. 2013). In Clark, the petitioner, Heidi Heffron-Clark, inherited an IRA worth approximately $450,000. The IRA was originally established by the petitioner’s mother as a traditional IRA and became an inherited IRA upon her death in 2001. The petitioner elected to begin monthly distributions from the inherited IRA, decreasing its value to approximately $300,000 at the time of petitioner’s Chapter 7 bankruptcy filing in 2010. In Bankruptcy Court, the petitioner argued that the inherited IRA should be excluded from the bankruptcy estate under a Bankruptcy Code’s exemption for “retirement funds.” 111 U.S.C. sec. 522(b)(2). The Bankruptcy Court disagreed, holding instead that an inherited IRA is not a “retirement fund” exempt from the bankruptcy estate. The district court reversed, but the Seventh Circuit agreed with the Bankruptcy Court, creating a split with the Fifth Circuit’s decision in In re Chilton, 674 F.2d 486 (2012).
In a unanimous decision written by Justice Sotomayor, the Supreme Court affirmed the Seventh Circuit’s decision that an inherited IRA is not a “retirement fund” exempt from the bankruptcy estate. After consulting the American Heritage Dictionary, the Court construed the phrase “retirement fund” to mean “sums of money set aside for the day an individual stops working.” According to the Court, traditional IRAs and Roth IRAs are “retirement funds” exempt from bankruptcy because the tax code encourages such IRA holders to save for retirement by making tax-favored contributions to the IRA and imposes a 10 percent penalty for withdrawing IRA funds before age 59-1/2. By contrast, the tax rules prohibit any further contributions to an inherited IRA after the original holder’s death, and no 10% penalty applies for withdrawals before age 59-1/2 from an inherited IRA. Further, the tax code requires that distributions must begin to an inherited IRA holder within a year after the original holder’s death (based on the inheritor’s life expectancy), assuming the original IRA holder had commenced distribution prior to death), or, alternatively, the IRA holder must withdraw all of the IRA funds within five years of the death. These differences convinced the Court that the holder of an inherited IRA is not the one setting aside sums of money for the day he or she stops working. Instead, the inherited IRA holder is merely collecting from someone else’s retirement fund. For these reasons, the Court concluded that the balance of interests between the debtor and creditors in bankruptcy weighs in this case in favor of the creditors.
It is worth noting that Clark involves a daughter’s inheritance of her mother’s IRA. The rules differ when the person inheriting the IRA is a spouse. While a spouse who inherits an IRA is initially subject to the inherited IRA rules, the spouse has the right to recharacterize the inherited IRA as his or her own IRA. In that instance, the recharacterized IRA is subject to the same rules as a traditional or Roth IRA as if the spouse was the original IRA holder. Thus, it may be reasonable to conclude that a spouse’s recharacterized IRA could be excluded from the bankruptcy estate as an exempt “retirement fund” even after Clark. A spouse who inherits an IRA should consider making the election to recharacterize it if bankruptcy is a possibility. Further, a non-spouse who inherits an IRA may want to take the risk of bankruptcy into account when deciding on the timing of distributions. Finally, IRA holders who have named a non-spouse beneficiary may want to reconsider their estate planning with Clark in mind.