Advanced Underwriting Consultants

Ask the Experts – July 9, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are inherited IRA funds exempt from creditors in bankruptcy?

Answer: It depends on the state. All states have their own bankruptcy exemption laws, but regardless of whether a state opts out of the federal bankruptcy protections, retirement funds held within a tax-qualified retirement account must be protected from creditors in bankruptcy.

At first this might seem like a pretty simple rule—for example, 401(k) accounts, governmental 457(b) plans, 403(b) tax-sheltered annuities, and IRAs (up to $1,245,475) are all excludable from the bankruptcy estate. Does this mean inherited IRAs are protected as well? After all, an inherited IRA is still an “individual retirement account.”

On June 6, the Supreme Court addressed the issue of whether funds held inside an inherited IRA qualify as “retirement funds” within the meaning of the bankruptcy code. The Court held that they are not.

In Clark v. Rameker, Heidi Heffron-Clark, a Wisconsin resident, inherited an IRA from her mother. Ms. Heffron-Clark thereafter filed for bankruptcy and sought to exempt her $300,000 inherited IRA from the bankruptcy estate under the federal bankruptcy exemption laws. She argued that the IRA exemption applies, so she should be able to exclude the IRA from her bankruptcy estate.

The Supreme Court disagreed. It held that funds held inside an inherited IRA are not retirement funds. But how are funds held inside of a “retirement account” not retirement funds?

To fully understand the decision of the Court and its reasoning, it’s important to understand the difference between a traditional IRA and an inherited IRA.

With a traditional IRA the owner may make contributions until he turns age 70 ½, at which point he is required to start taking distributions (RMDs). Additionally, until he turns 59 ½, if he withdraws any money from his IRA, he faces a 10 percent penalty unless an exception applies.

On the other hand, inherited IRAs cannot receive contributions, so the owner may never invest additional money into the account. Additionally, regardless of the new owner’s age, he must take periodic distributions from the account or fully distribute it within five years. Finally, there are no penalties for taking distributions prior to age 59 ½.

After taking into account the differences between traditional IRAs and inherited IRAs, the Court looked at what it means for funds to be defined as “retirement funds.” It held that the term means “money set aside for the day an individual stops working.” It reasoned that funds inside an inherited IRA, which must be distributed either within five years from the original owner’s death or stretched throughout the life of the beneficiary, couldn’t possibly be set aside for a later date.

The Court also looked at the characteristics of an inherited IRA to determine whether funds held inside such an account could be viewed as money set aside for retirement. The Court pointed to three aspects of inherited IRAs to show that such IRAs are not retirement funds.

      • The holder of the inherited IRA may never invest additional money in the account.
      • The holder of the inherited IRA must take RMDs.
      • The holder of the inherited IRA may take distributions at any time without penalty.

Because inherited IRAs are much more restricted than traditional or Roth IRAs, the Court found that an inherited IRA should not be considered a retirement vehicle. Therefore, the funds inside an inherited IRA are not retirement funds for federal bankruptcy purposes and are not protected from creditors.

What is the lesson of the Clark case? Inherited IRAs are not protected under federal law during bankruptcy. States may still carve out their own exemptions for inherited IRAs, though.

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