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US Supreme Court Rules that Inherited IRA Funds are Not Exempt from Claims of Creditors in Bankruptcy Cases
On June 12, 2014, the United States Supreme Court ruled in the case of Clark v. Rameker that inherited individual retirement account (IRA) funds are not “retirement funds” for purposes of the exemption of certain assets from claims of creditors in bankruptcy cases. The case has a long history and has now been considered by four courts with the case finally arriving upon the steps of the U.S. Supreme Court in this term. The holding has important implications for both debtors and creditors, as it makes clear the distinction between retirement funds that are earned and set aside during one’s working life and those that are inherited from a third party as a bequest.
Economically and demographically, the issue of whether inherited IRA funds are exempt from claims of creditors cannot be underestimated. Massive amounts of wealth are being passed down to future generations via inherited retirement vehicles as older Americans are dying. The largest component among U.S. retirement assets is IRAs, with nearly $6 Trillion in value. In the hands of the person who created the IRA, creditors have no right to the funds under federal bankruptcy laws. The question posed in this case is whether creditors have right to IRA funds if the creator of the IRA dies and the funds are inherited by someone other than her spouse.
The Facts in Clark v. Rameker
Brandon C. Clark and Heidi Heffron-Clark filed for Chapter 7 bankruptcy. Chapter 7 of the U.S. Bankruptcy Code is commonly known as a “liquidation” proceeding by which all of the debtor’s nonexempt property is sold and the proceeds distributed to creditors. Exemptions allow the debtor to keep a certain amount and certain types of property so the debtor can have a “fresh start” after the bankruptcy. The amount and types of property the debtor can exclude from the “bankruptcy estate” depend on specific exemptions and the value of the assets. Typically, Chapter 7 debtors have no such assets, so most of these proceedings are commonly referred to as “no asset” cases.
Contrary to most debtors seeking relief under Chapter 7, Ms. Clark filed bankruptcy and sought to exclude $300,000 in inherited IRA funds from the claims of creditors, using the “retirement funds” exemption under federal bankruptcy law. Ms. Clark inherited the $300,000 IRA from her deceased mother, Ruth Heffron. An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. The relevant statutory exemption language is for “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under” certain enumerated sections of the Internal Revenue Code, including the ones for IRAs. Therefore, Ms. Clark sought to exclude these funds from claims of her creditors in the bankruptcy proceeding.
The Court Decisions
Rameker, the Trustee, acting in the best interests of all creditors, objected to the claim of Ms. Clark that the inherited IRA was an exempt asset under federal law. The inherited funds indisputably satisfied the latter part of the statutory test, as they were exempt from taxation under a listed section in the Bankruptcy Code. The battle was over whether the inherited IRA constituted “retirement funds” within the meaning of that exemption. The Bankruptcy Court agreed with the Trustee’s argument that inherited IRAs did not fall within the exemption, concluding that an inherited IRA does not share the same characteristics as a traditional IRA. That judge disallowed the exemption, making the $300,000 in inherited funds available to pay creditor claims of Brandon and Heidi Clark. On appeal, the District Court reversed the Bankruptcy Court’s decision, finding no material distinction between retirements funds set aside by Ms. Clark in planning for her retirement during her working years and those inherited from a deceased family member. The District Court reasoned that the exemption for retirement funds covers any account in which the funds were originally accumulated for retirement purposes. The Trustee appealed the District Judge’s ruling to the Seventh Circuit Court of Appeals.
The Seventh Circuit Court reversed the District Judge’s finding, disagreeing with the Fifth Circuit and the Eighth Circuit, as well as the clear majority of lower courts which had held that an inherited IRA is exempt under the Bankruptcy Code. The Seventh Circuit determined that the inherited IRA must by law begin distributing its assets to Ms. Clark within one (1) year of her mother’s death and that the entire balance must be paid out to Ms. Clark within five (5) years of that date. As noted by the Seventh Circuit, “an inherited IRA is a time-limited tax-deferral vehicle, but not a place to hold wealth for use after the new owner’s retirement.” By the time the Clarks filed for bankruptcy, Ruth Heffron’s IRA funds did not represent anyone’s retirement funds, since Ruth was dead and Ms. Clark simply inherited the money. The monies within the inherited IRA therefore lost their status as retirement funds and instead became simply cash in Ms. Clark’s possession. As stated by the Seventh Circuit, “an inherited IRA does not have the economic attributes of a retirement vehicle, because the money cannot be held in the account until the current owner’s retirement.”
The Clarks then appealed this adverse decision to the U.S. Supreme Court. Contrary to their hopes and the American Bankruptcy Institute (who stated that the oral argument before the Supreme Court favored the debtor’s position), the Supreme Court affirmed the decision of the Seventh Circuit. The U.S. Supreme court ruled that funds in inherited IRAs are not “retirement funds” within the meaning of the Bankruptcy Code and therefore nonexempt assets of the debtors’ bankruptcy estate. Ms. Clark argued that the inherited IRA funds should be considered exempt, as the IRA funds had that status when set aside initially in the account by her mother, and nothing in the statute limited the exemption to “the debtor’s” retirement funds. The Trustee argued that after being inherited, in the hands of the non‐spousal debtor (Ms. Clark), the IRA funds no longer constituted retirement funds. While still tax exempt, the attributes relevant to retirement had changed significantly so as to negate that characterization; for example, Ms. Clark could withdraw the money immediately (before age 59½), and indeed was not even permitted to wait until she was 59½, but had to start withdrawals within one year of her mother’s death. The Trustee also noted that Ms. Clark could neither make new retirement contributions to the fund nor roll it over to a different retirement vehicle that she had created during her working life. The Seventh Circuit found the Trustee’s arguments both accurate and persuasive, as did the Supreme Court.
Picking up on the analysis of the Seventh Circuit, the Supreme Court noted three distinguishing characteristics between traditional and inherited IRAs: The holder of an inherited IRA (1) may never invest additional money in the account; (2) is required to withdraw money from the account, no matter how far the holder is from retirement; and (3) may withdraw the entire account at any time and use it for any purpose without penalty. The Supreme Court observed that allowing debtors to protect funds in traditional and Roth IRAs ensures that debtors will be able to meet their basic needs during their retirement, but nothing about an inherited IRA’s legal characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for purposes of current consumption. The possibility that an account holder can leave an inherited IRA intact until retirement and take only the required minimum distributions does not mean that an inherited IRA bears the legal characteristics of retirement funds.
Justice Sotomayor concluded her opinion with the following commentary:
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.”
The Supreme Court’s decision in Clark v. Rameker provides consistent application of the rules governing retirement funds in the Internal Revenue Code with the exemptions contained in the Bankruptcy Code. In short, debtors can protect from claims of creditors retirement funds that they earned and set aside during their working lives as part of thoughtful planning but not such funds that constitute nothing more than inherited wealth. Consistent application of such rules will allow debtors and creditors to achieve more predictable outcomes at all level of interaction, from lending decisions to the working out of defaulted obligations to foreclosure and litigation. This author also believes that the ruling here is consistent with the country’s social and moral fabric in which work and the fruits of one’s labor is regarded with greater value and importance than inherited wealth will ever be.
Inherited IRA funds held by one other than the deceased person’s spouse are not exempt assets in bankruptcy and are instead subject to creditor claims.