Supreme Court: Inherited IRAs are not retirement funds

The decision resolving a circuit split allows an inherited IRA to be included in a bankruptcy estate.
 
The U.S. Supreme Court in Clark v. Rameker held that funds in an inherited individual retirement account (IRA) were not retirement funds that were exempt from a husband-and-wife debtors’ bankruptcy estate.

Facts: The debtors in the case filed for Chapter 7 bankruptcy and sought under Section 522(b)(3)(C) of the Bankruptcy Code (11 U.S.C. §522(b)(3)(C)) to exclude from the bankruptcy estate approximately $300,000 in an IRA the wife had inherited from her mother, because the money was “retirement funds” held in a tax-exempt account. The bankruptcy trustee and unsecured creditors objected, and a bankruptcy court disallowed the exemption because the funds in an inherited IRA are not segregated for, or only distributed on, a person’s retirement. A district court reversed the bankruptcy court, holding that the funds were “retirement funds” because they had originally been accumulated for retirement purposes. The Seventh Circuit reversed the district court. The debtors appealed to the Supreme Court, which granted certiorari to resolve a split between the Seventh Circuit and the Fifth Circuit (in In re Chilton, 674 F.3d 486 (5th Cir. 2012)). For more, see “Tax Matters: Supreme Court to Hear Bankruptcy Treatment of Inherited IRA,” JofA, March 2014, page 68, and “Protection From Creditors for Retirement Plan Assets,” The Tax Adviser, Jan. 2014, page 30.

Issues: Bankruptcy Code Section 522(b)(3)(C) excludes retirement funds from a bankruptcy estate to the extent they are in a fund or account that is exempt from taxation under Sec. 401, 403, 408, 408A, 414, 457, or 501(a). The debtors argued that the inherited IRA retained its status as retirement funds because the original owner set the funds aside for retirement, and the owner’s death did not affect the funds in the account.

Holding: The Supreme Court held that funds in an inherited IRA are not retirement funds and thus cannot be excluded from a bankruptcy estate. As the Court explained, inherited IRAs have three legal characteristics that led it to conclude they are not retirement accounts. First, inherited IRA owners may not make additional contributions to the account. Second, owners must withdraw funds from their accounts, regardless of how many years they are from retirement age. Third, owners are not subject to any age-related penalties for withdrawals from their accounts. Taking all of these characteristics together, the Supreme Court agreed with the Seventh Circuit that “[f]unds held in inherited IRAs accordingly constitute ‘a pot of money that can be freely used for current consumption,’ … not funds objectively set aside for one’s retirement” (Clark, slip op. at 6, quoting the circuit court (citations omitted)).

According to the Supreme Court, allowing debtors to protect funds in traditional retirement accounts but not in inherited IRAs permits the Bankruptcy Code to achieve a balance between debtors and creditors. These funds are protected to help ensure that debtors will be able to meet their basic needs during their retirement years. Allowing bankruptcy exemptions for inherited IRAs and other funds that are not restricted to use for retirement would allow debtors to use those funds for current consumption after bankruptcy proceedings are complete, which the Court stated would change the Bankruptcy Code’s “ ‘fresh start’ … into a ‘free pass’ ” (Clark, slip op. at 7 (citations omitted)).

The Court rejected the debtors’ argument that because the account was originally a retirement account when the original owner created it, it retained that character after it was inherited. According to the Court, the term “ ‘retirement funds’ implies that the funds are currently in an account set aside for retirement, not that they were set aside for that purpose at some prior date by an entirely different person” (Clark, slip op. at 8).

Clark v. Rameker, No. 13-299 (U.S. 6/12/14), aff’g 714 F.3d 559 (7th Cir. 2013)

By Sally P. Schreiber, J.D., a JofA senior editor.