The U.S. Supreme Court resolved a split among the circuits, holding that assets in non-spousal inherited individual retirement accounts are not exempt or protected from claims of the heir’s creditors. Clark v. Rameker, 573 U.S. ___ (2014) (No. 13-299; June 12, 2014).

“Inherited” IRAs hold funds from persons who established Individual Retirement Accounts for their own use and died before depleting the funds in those accounts. The U.S. Supreme Court affirmed the judgment by the Seventh Circuit Court of Appeals {In re Clark, 714 F.3d 559 (7th Cir. 2013)}.

Writing for a unanimous Court, Justice Sotomayor’s decision adopts the ordinary meaning of “retirement funds” as used in 11 U.S.C. §522(b)(3)(C)’s bankruptcy exemption. “Retirement funds” are sums of money set aside for the day an individual stops working. To decide whether a particular set of funds falls within the definition, courts are not to look at how a debtor uses or intends to use the funds. Instead, courts are to look at the legal characteristics of the account in which the funds are held, and ask whether the account is set aside for the day when an individual stops working.

The Court identified three legal characteristics of non-spousal inherited IRAs proving that funds in such accounts are not set aside for the purpose of retirement. First, the holder of the inherited IRA may never invest additional money in the account. Second, the holder of the inherited IRA is required to withdraw money from the account, no matter how many years the holder may be from retirement. Third, the holder of the inherited IRA may withdraw the entire balance of the account at any time and for any reason, without penalty.

According to the Court, this reading of the exemption is also consistent with the purpose of the Bankruptcy Code’s exemption provisions, which generally “effectuate a careful balance between the interests of creditors and debtors.” Allowing debtors to protect funds held in both traditional and Roth IRAs comports with this purpose by helping to ensure that debtors can meet their basic needs during retirement years. The inherited non-spousal IRA, however, is not the same because nothing about its legal characteristics would prevent or even discourage the individual “from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a ‘fresh start’ into a ‘free pass.’”

The Court considered and rejected several arguments made by the debtor, including the debtor’s argument that funds set aside by the initial owner of a retirement account for retirement should be considered “retirement funds” even after inherited. Nor was the Court persuaded by the fact that many of Bankruptcy Code §522’s other exemptions refer to the “debtor’s interest” in various kinds of property – words omitted in this retirement fund exemption provision - suggesting that the monies do not have to be for the debtor’s retirement. The Court concluded that Congress used the phrase not to distinguish between a debtor’s assets and the assets of another, but rather to set a limit on the value of the particular asset that a debtor may exempt. The Court was unpersuaded by the debtor’s arguments based upon the grammatical construction of the exemption provision, and did not give any weight to the fact that an inherited IRA holder can choose to use the inherited IRA for retirement purposes.

For estate planning and asset protection purposes, consider making an IRA distributable to a qualified trust as the beneficiary, which would include spendthrift and other protective provisions to protect the inherited IRA funds from the beneficiary’s creditors. If the beneficiary’s life expectancy is desired as the measuring period to “stretch” the payment period of the IRA, the trust should be structured as a so called “conduit” trust, which may then subject the minimum required distributions from the IRA to the trust, which in turn are distributed from the trust to the beneficiary, ultimately to the reach of the beneficiary’s creditors, but this type of trust structure would still mitigate the effect of the Clark decision by providing creditor protection over the remaining undistributed principal balance in the IRA.