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.