Supreme Court holds inherited IRAs are not retirement funds

In a unanimous opinion written by Justice Sonia Sotomayor, the U.S. Supreme Court on Thursday held that funds from an inherited IRA were not retirement funds that were exempt from the debtor’s bankruptcy estate (Clark v. Rameker, No. 13-299 (U.S. 6/12/14), aff’g 714 F.3d 559 (7th Cir. 2013)). The Supreme Court granted certiorari to resolve a split between the Seventh Circuit and the Fifth Circuit (in In re Chilton, 674 F.3d 486 (2012)), and affirmed the Seventh Circuit’s decision in Clark.

The taxpayers in the case filed for Chapter 7 bankruptcy and sought to exclude approximately $300,000 in an inherited IRA from the bankruptcy estate on the grounds that the money was “retirement funds” under Section 522(b)(3)(C) of the Bankruptcy Code (11 U.S.C. §522(b)(3)(C)).

Bankruptcy Code Section 522(b)(3)(C) excludes retirement funds from a bankruptcy estate to the extent those funds are in a fund or account that is exempt from taxation under Sec. 401, 403, 408, 408A, 414, 457, or 501(a). However, as the Supreme Court explained, although traditional retirement accounts, such as IRAs or Roth IRAs, are included in this definition, inherited IRAs are not because they do not operate as retirement accounts.

The Supreme Court pointed to three legal characteristics of inherited IRAs 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. 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 inherited IRAs, permits the Bankruptcy Code to achieve a balance between debtors and creditors. Debtors are assured that they will be able to meet their basic needs during their retirement years. Allowing bankruptcy exemptions for funds that are not restricted to use for retirement, as inherited IRAs are not, would allow debtors to use those funds for current consumption after bankruptcy proceedings are complete, changing the Bankruptcy Code’s “‘fresh start’ into a ‘free pass’” (Clark, slip op. at 7 (citations omitted)).

The Court rejected the debtor’s argument that, because the account was originally a retirement account when the debtor’s mother created it, it retained that character after it was inherited. According to the Court, the use of 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).

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.