What Happens To Inherited IRAs in Bankruptcy?

Let us discuss IRAs.

You may be aware that there is bankruptcy protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts up to $1 million in IRAs created and funded by the debtor. Employer plans have even more favorable protection.

Why? The government has expressed interest that citizens be able to save for their retirement. This diminishes the odds of future government assistance and deemed in the public interest.

Fair enough. But I have one more question.

Let us say that you inherited the IRA. Does the above protection still apply to you?

Why wouldn’t it, you might ask. It is like an ice cream bar. It is still an ice cream bar whether you or I take it from the freezer, right?

This very question made it to the Supreme Court in the recent case of Clark v Rameker. While a bankruptcy case, it does have tax implications.

In 2001 Ruth Heffron established a traditional IRA and named her daughter as beneficiary.

NOTE:  “Traditional” means the classic IRA: contributions to it are deductible and withdrawals from it are taxable. Contrast this with a “nondeductible” IRA (contributions are nondeductible and withdrawals are taxable, according to a formula) and Roths (contributions are nondeductible and withdrawals are nontaxable).

Mrs Heffron passed away a year later – 2001 – and left approximately $400,000 to her daughter in the IRA account. Inherited IRAs have special rules on distributions, and one has to take distributions over a life expectancy or withdraw the entire balance within five years. Her daughter – Ms. Heffron-Clark - elected to use life expectancy with monthly distributions.

Fast forward to 2010 and Ms. Heffron-Clark and her husband file for Chapter 7 bankruptcy. The IRA has approximately $300,000 remaining, and you can bet that the couple considered the IRA to be an exempt asset. The unsecured creditors of the bankruptcy estate disagreed, thus beginning the litigation.

·       The Bankruptcy Court said that the IRA was not exempt and could be reached by creditors.

·       The District Court reversed, saying that the IRA was exempt and could not be reached by creditors.

·       The Appeals Court for the Seventh Circuit reversed, saying that the IRA was not exempt and could be reached by creditors.

This set up disagreement between the Fifth and Seventh Circuits, so the Supreme Court agreed to hear the case.

Believe it or not, the Bankruptcy Code does not define the term “retirement funds,” resulting in the above courts drawing such different conclusions. The Supreme Court declared that the term must be defined in order to arrive at a correct conclusion. The Court looked a dictionary and saw that “retirement” is defined as …

       … withdrawal from one’s occupation, business or office.”

The Court wanted to look at the legal characteristics of funds set aside for the day one stops working. It focused on three:

(1)  One can put additional monies into a retirement account.

POINT: One cannot put additional monies into an inherited account. In fact, if one inherits again, one cannot mingle the two accounts. Each is to remain separate and unique.

COUNTERPOINT: One cannot put additional monies into an IRA after age 70 ½.

(2)  Holders of an inherited account are required to begin distributions in the year following the death.

POINT: There are no age 59 ½ or 70 ½ minimum distribution requirements here. It does not matter whether the beneficiary is three years old or ninety-three; distributions must begin in the year following death, unless one fully depletes the account over 5 years.

OBSERVATION: The Court asked obvious question: how does this distribution requirement tie-in to the beneficiary’s retirement in any way?

(3)  The beneficiary can withdraw the entire balance at any time, without penalty.

POINT: You and I cannot do that with our own IRA until we are age 59 ½. 

OBSERVATION”: The Court noted that there is a ‘stick” if one wants to access a traditional IRA early – the 10% penalty. That expresses Congress’ intent to discourage use of traditional IRA s for day-to-day non-retirement purposes. The inherited IRA has no such prohibition. What does that say about Congress’ intent with inherited IRAs?

Rest assured that Ms Heffron-Clark was arguing furiously that the funds in that inherited IRA are “retirement funds” because, at some point, they were set aside for retirement.

The Court looked at the three criteria above and said that the inherited IRA certainly constitutes “funds,” but it cannot see how they rise to the level of “retirement funds.” They simply do not have the characteristics of normal retirement funds.

The Supreme Court unanimously decided that an inherited IRA do not constitute “retirement funds” and are not exempt from bankruptcy claims. Ms. Heffron-Clark’s creditors could in fact reach that $300 grand.

Granted, this is a bankruptcy case, but I see two immediate tax consequences from this decision:

(1) First, a surviving spouse (that is, the widow or widower) has a tax  option offered no other IRA beneficiary.

The surviving spouse can take the IRA as an inherited IRA (and be subject to bankruptcy claims) or he/she can rollover the IRA to his/her own personal name.

In the past, this decision was sometimes made based on the survivor’s age. For example, if the surviving spouse thought he/she might need the money before age 59 ½, the tax planner would lean towards an inherited IRA. Why? Because there is no 10% penalty for early withdrawals from an inherited IRA. There would be penalties on early withdrawals from a rollover IRA.

This decision now gives planners another reason to consider a spousal rollover.

(2) Second, there may be increased attention to IRA accumulation trusts.

A trust is allowed to be an IRA beneficiary, but at the cost of some highly specific tax rules. There are two types of permitted trusts. The first is the conduit trust. The trust receives the annual minimum required distributions (MRDs) but is required to immediately pay them out to the beneficiary.  While you may wonder what purpose this trust serves, consider that the trust – while unable to protect the annual income – can still protect the principal of the trust.

The second type is the accumulation trust. It is eponymous: it accumulates. There are no required distributions to the beneficiaries. The tax cost for this can be enormous, however. A trust reaches the maximum federal tax rate at the insanely low threshold of approximately $12,000. Obviously, this strategy works best when the beneficiaries are themselves at the maximum tax bracket.

The other point that occurred to me is the future of stretch IRAs. There has been considerable discussion about imposing a five-year distribution requirement (with very limited exceptions) on inherited IRAs. This of course is in response to the popular tax strategy of “stretch” IRAs. The stretch is easy to explain: I leave my IRA to my granddaughter. The IRA resets its mandatory distributions, using her life expectancy rather than mine (which is swell, as I am dead). Say that she is age 11. Whereas there are mandatory distributions, those distributions are spread out over the life expectancy of an eleven-year-old girl. That is the purpose and use of the “stretch.”

Consider that the Court just decided that an inherited IRA does not constitute “retirement funds.” This may make it easier for Congress to eventually do away with stretch IRAs.