Law Tips: What Do The Courts Say About An Inherited IRA?

Recently Tom Yoder, ICLEF Bankruptcy Law expert, brought his usual scintillating discussion of cases to ICLEF’s 36th Annual Indiana Law Update. The case of Clark v. Rameker, 134 S. Ct. 2242 (2014) is an example of the issues he raised for the attention of practitioners inside and outside the bankruptcy area. His analysis of this case and the path it took from Bankruptcy Court to District Court to U. S. Supreme Court points out how an inherited IRA might have an unexpected end. Be sure to read to the end for the “Yoder Closing.”

Debtor’s mother created a traditional IRA and named Debtor as the beneficiary. After Debtor’s mother passed, Debtor inherited the account. When Debtor and her husband filed for Chapter 7 relief, they alleged the IRA, totaling about $300,000, was excluded from their bankruptcy estate by virtue of the exemption afforded “retirement funds” under § 522(b )(3)(C). The Bankruptcy Court denied the exemption on the basis that an “inherited” IRA is not a “retirement fund.” The District Court reversed, feeling the account was close enough to qualify for the exemption since the funds were originally accumulated for retirement purposes. The 7th Circuit reversed the District Court, noting substantial differences between traditional IRAs and the inherited variety.

Since creating a split in the Circuits, the U.S. Supreme Court agreed to review the case. Speaking for a unanimous Court, Justice Sotomayor agreed with the 7th Circuit’s analysis, focusing primarily on the differences between inherited and traditional IRAs. For the purposes of this case, contributions to traditional IRAs are tax -deductible, but not to inherited IRAs. A withdrawal from a traditional IRA before the account holder reaches the age of 59 ½, is subjected to a ten percent penalty. Once an account holder dies, and the funds are transferred to a beneficiary, the IRA becomes an inherited IRA. If the account is inherited by a person other than the owner’s spouse, the IRA funds may not be “rolled over” into an existing IRA, but instead, must be considered an inherited IRA.

Accordingly, the Court held inherited IRAs do not fall under the “retirement funds” exemption. Justice Sotomayor noted there are three significant differences between the characteristics of a traditional IRA, the “quintessential retirement fund,” and an inherited IRA. First, an inherited IRA, as opposed to a traditional IRA, cannot be contributed or added to regularly over time. Second, account holders are required to withdraw money from inherited IRAs at specific times regardless of whether they qualify as retirement distributions; hence, the Debtor here chose to withdraw yearly distributions over the last ten years. Finally, an account holder of an inherited IRA may withdraw the entire account balance without penalty before the age of 59 ½. Traditional IRAs, of course, are subject to a withdrawal penalty if the account holder is younger than 59 ½.

These aforementioned differences led the Court to conclude inherited IRAs do not fulfill the Code exemption’s intent to help support and protect a debtor’s needs by providing for the future. As elegantly worded, Justice Sotomayor ruled that allowing an inherited IRA to be considered a “retirement fund” under the applicable exemption would shift the Code’s purpose in providing a “fresh start” into a “free pass.”

The Court was not persuaded by Debtors’ statutory construction arguments otherwise, finding Debtors’ arguments contravened the exemption statute’s express language and purpose. Justice Sotomayor ruled “retirement funds,” under normal usage, refers to setting money aside for retirement, not for the benefit of someone else at a later date. Accordingly, she found it contrary to logic for funds deposited in a traditional IRA to be withdrawn, transferred to someone else, and then considered “retirement funds” simply because the funds originally started out as such. Even if an individual uses the inherited IRA for retirement purposes, it does not mean that inherited IRAs have the same legal characteristics as a traditional IRA.

In Tom’s discussion at the Indiana Law Update he provides the following background and personal comment about the decision in Clark v. Ramecker:

“Don’t get fooled by the difference between federal exemptions and state exemptions in this instance. 70% of the states, including Indiana, have opted out of the federal exemptions. However, while the federal exemption exempts retirement funds, the Indiana exemption exempts retirement plans. I am here to tell you that there is no difference as far as I’m concerned between those two concepts. So, the way this case came out is going to be the way I say it will come out if it ever becomes an issue in Indiana. For those of you who do estate planning, if you are dealing with an inherited IRA, if your clients have to file for bankruptcy the IRA will not be exempt”……..Says Yoder.

The Yoder presentation on key bankruptcy issues accompanies other enlightening sessions of the 36th Annual Indiana Law Update. If you haven’t already had the opportunity to attend this year’s seminar, Click Here for On Demand or Video Replay Seminars near you.

_________________________________________________________________________________

About our Law Tips faculty participant:
Thomas P. Yoder is a partner with law firm of Barrett & McNagny LLP in Fort Wayne, Indiana, and concentrates his practice in the areas of business bankruptcy, creditors’ rights and general insolvency matters. He is a Fellow of the American College of Bankruptcy. He has also written and lectured extensively on bankruptcy and insolvency-related topics and is a co-author of Bankruptcy- A Survival Guide for Lenders (First ed. 1997; Second ed. 2008), published by the American Bankruptcy Institute and winner of the ABI’ s Outstanding Publications Award (1997).

About our Law Tips blogger:
Nancy Hurley has long-standing connections with Indiana lawyers. She was formerly a member of the ISBA and IBF staffs for over 30 years. Nancy’s latest lifestyle venture is with ICLEF. We are utilizing her exceptional writing and interviewing skills while exploring how her Indiana-lawyer background fits with ICLEF’s needs. When she isn’t ferreting out new topics for Law Tips, her work can be found in our Speaker Spotlight blogs, postings on the ICLEF Facebook and Twitter pages, and other places her legal experience lends itself.

Thank you for reading Law Tips. You may subscribe to this weekly blog through the RSS link at the top of this page.  Also, you are encouraged to comment below or email Nancy. She welcomes your input as she continues to sift through the treasure trove of knowledge of our CLE faculty to share with you.

ICLEF • Indiana Continuing Legal Education Forum, Indianapolis, IN

Leave a Reply