Inherited IRAs Not Protected in Bankruptcy

If you directly inherited an IRA and are facing bankruptcy, these funds are no longer protected from creditors.

In Clark v. Rameker (In re Clark), No. 13-299, the U.S. Supreme Court unanimously ruled that inherited IRAs do not qualify under the “retirement funds” bankruptcy exemption. As a result, non-spouses inheriting an IRA may no longer protect the funds from creditors after filing bankruptcy and spouses have more incentive to “roll over” inherited IRA funds.

Before the Supreme Court decided Clark, there was a split between the 5th and 7th Circuit Courts of Appeals regarding exactly what the “retirement funds” bankruptcy exemption covered. In Chilton v. Moser, the 5th Circuit previously held that inherited IRAs were exempt from the bankruptcy estate because the “retirement funds” exemption never stated that the retirement funds had to be the debtor’s. In Clark v. Rameker, the 7th Circuit disagreed and held that inherited IRAs were not exempt because they were an “opportunity for current consumption, not a fund of retirement savings.” The disagreement stemmed from the interpretation of what “retirement funds” included.

The Supreme Court settled the issue and agreed with the 7th Circuit’s holding. In its ruling, the Court pointed out two distinct differences between traditional or Roth IRAs and inherited IRAs. First, an individual with an inherited IRA can never make contributions to the IRA. Second, it is required that money be withdrawn from the inherited IRA, either annually or entirely, to avoid penalties. In contrast, a traditional IRA incurs penalties if money is withdrawn before a certain age. The Court found that these differences mean an inherited IRA is not a “retirement fund” since its intended purpose is no longer saving for retirement.

The Court rejected the 5th Circuit’s argument that the bankruptcy exemption did not require the retirement funds to be the funds of the debtor. Under that argument, the Court stated, any monetary asset may be traced back to another’s retirement account and become excludable from creditors. This would violate the two purposes of the Bankruptcy Code—“preserving debtors’ ability to meet their basic needs and ensuring that they have a ‘fresh start’”—and instead give debtors a “free pass.”

The new decision does not leave those wishing to transfer IRAs on their death without options. Spouses inheriting IRAs retain the option to “roll over” the inherited IRA into their own or a new IRA. If a current IRA owner wishes to leave his or her IRA to a beneficiary upon the owner’s death, the best course of action is to leave the IRA to a trust for the benefit of the individual instead of directly to an individual.

If you have questions about the state of your IRA beneficiary, contact an estate planning attorney for information regarding the effects of the new Supreme Court decision.