Supreme Court Rules That Inherited IRAs Not Exempt
By: Michael R. Blaskowsky, Columbia River Law Group
In a defeat for debtors in bankruptcy, the Supreme Court ruled yesterday that a debtor filing for bankruptcy cannot claim an exemption in an inherited IRA as “retirement funds” under 11 U.S.C. §§522(b)(3)(C) and (d)(12). This case resolved a circuit split between the Fifth Circuit (holding that an inherited IRA is exempt) and the Seventh Circuit (holding that a Chapter 7 Trustee can distribute such funds to creditors).
The facts of the case are outlined in my March 25 article Exemption for Inherited IRA Before Supreme Court. Writing for a unanimous Supreme Court, Justice Sotomayor noted that the term “retirement funds” is not defined in the Bankruptcy Code, but “is . . . properly understood to mean sums of money set aside for the day an individual stops working”, and outlined “[t]hree legal characteristics of inherited IRAs [which led the Court] to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement”:
· Tax law prohibits the owner of the inherited IRA from depositing additional funds into the account. The Court noted that “the entire purpose of traditional and Roth IRAs is to provide tax incentives for accountholders to contribute regularly and over time to their retirement savings”, a concept not applicable to inherited IRAs.
· Tax law requires the owner of the account to withdraw all of the money within five years from the decedent’s death, or to take minimum annual distributions, regardless of the age or employment status of the account owner. In light of that fact, the Court argued that “the tax rules governing inherited IRAs routinely lead to their diminution over time, regardless of their holders’ proximity to retirement, is hardly a feature one would expect of an account set aside for retirement”.
· The owner of an inherited IRA can withdraw from the account at any age and for any purpose without the potential penalty associated with withdrawals from traditional or Roth IRAs. The Court’s rationale here focused on the perspective that while “a withdrawal from a traditional or Roth IRA prior to the age of 59½ triggers a 10 percent tax penalty subject to narrow exceptions . . . a rule that encourages individuals to leave such funds untouched until retirement age[,] there is no similar limit on the holder of an inherited IRA. Funds 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.”
In interpreting the phrase “retirement funds” in this way, the Court indicated that it was attempting to strike a balance between the legitimate interest of debtors and creditors:
“On the one hand, we have noted that ‘every asset the [Bankruptcy] Code permits a debtor to withdraw from the estate is an asset that is not available to . . . creditors.’ . . . On the other hand, exemptions serve the important purpose of ‘protect[ing] the debtor’s essential needs.’ . . . Allowing debtors to protect funds held in traditional and Roth IRAs comports with this purpose by helping to ensure that debtors will be able to meet their basic needs during their retirement years. At the same time, the legal limitations on traditional and Roth IRAs ensure that debtors who hold such accounts (but who have not yet reached retirement age) do not enjoy a cash windfall by virtue of the exemption—such debtors are instead required to wait until age 59½ before they may withdraw the funds penalty-free. The same cannot be said of an inherited IRA. For if an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a ‘fresh start,’ . . . into a ‘free pass,’ . . . . We decline to read the retirement funds provision in that manner.”
As a debtor’s attorney, this ruling is obviously a disappointment, but I suspect is legally correct. However, as noted by one commentator, such a result can be avoided if the original owner of the IRA had left her daughter the IRA in a trust or in a trusteed IRA. Properly drafted, under Section 541(c)(2) of the Bankruptcy Code, a debtor’s interest in a trust can usually be exempted by a debtor filing bankruptcy so that the Trustee cannot access the funds in the trust for the benefit of creditors.
This post is intended to be purely informational in nature, and cannot be considered legal advice. If you have questions related to bankruptcy, please call our office at (503) 545-1061 (Oregon cases) or (360) 836-4238 (Washington cases) to schedule a free initial consultation.