Riddle Me This: When is a Retirement Account Not a Retirement Account?

Answer:  when it’s inherited from someone else, silly!

Many clients use their IRA for a significant, if not primary, part of their retirement plan. After all, both traditional IRA’s and ROTH IRAs are attractive for many reasons, chief among them tax-free growth and creditor protection. Bankruptcy protection for your own retirement accounts was expanded and strengthened by the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005. There has been a split in the circuits for nearly a decade over the question of whether funds in an inherited IRA are protected in bankruptcy. On June 12, 2014, in a rare display of unanimity, the United States Supreme Court answered that question with a resounding “no.” Specifically, SCOTUS held that funds held in inherited Individual Retirement Accounts are not “retirement funds” within the meaning of U.S.C. § 522(b)(3)(c) and therefore are not exempt from the bankruptcy estate. This renders inherited IRA funds to creditor claims in bankruptcy. Traditional and ROTH IRAs have typically been exempt from bankruptcy claims up to a $1 million limit ($1,245,475 as adjusted for inflation in 2014). The Circuits have taken opposing views. In the Eighth Circuit inherited IRAs have been exempt from bankruptcy claims, on the grounds that the funds are retirement funds in tax-exempt vehicles. Other Circuits (like the Seventh, out of which the Clark case arose), have held that inherited IRAs lack the requisite “retirement purpose” and are governed by a different set of rules than IRAs in the hands of their original owners. Inherited IRAs can be liquidated at any time without penalty, unlike an original IRA, which suffers a penalty if the owner withdraws assets before the age of 59 1/2 . The facts of the Clark case are as follows: Heidi Heffron-Clark inherited an IRA from her mother in 2001, who had named Heidi on the beneficiary designation form. The IRA was worth $450,000 at the mother’s death. Heidi had drawn the account down to approximately $300,000 before filing for Chapter 7 bankruptcy nine years later in October 2010. Heidi argued that the money constituted “retirement funds” and was not available to creditors. The creditors objected. The bankruptcy court agreed. The U.S. District Court for the Western District of Wisconsin reversed the bankruptcy court (finding in favor of Heidi) and the U.S. Court of Appeals for the Seventh Circuit overturned the District Court decision. By way of brief review, IRA accounts, employer sponsored retirement plans like 401(k)s and 403(b)s are accounts that an individual creates and funds for him or herself. The Supreme Court decision, written and issued by Judge Sonia Sotomayor, turned on the legal distinction between self-funded IRA’s and inherited IRAS, whether through an employer sponsored plan or a roll-over when you leave the company. The Court noted that, unlike IRA owners, inheritors cannot make additional contributions to the account. They can withdraw funds without penalty. By contrast, non-spouse inheritors of an IRA must withdraw the entire account balance in five years of the primary owner’s death or take out a minimum amount each year starting on December 31st of the year after the IRA owner dies. This applies to the inherited IRA whether it is a traditional IRA or a ROTH. The Court emphasized this distinction, reasoning that the bankruptcy code provision is intended to ensure that a filer has money during retirement, justifying its protection. This presents an interesting conundrum for spouses who inherit an IRA. Spousal inherited IRA’s receive slightly different treatment. An inheritor spouse can “roll over” the inherited IRA into her own IRA account and not take distributions until she reaches 70 ½, even if that date is later than the date the decedent spouse would have turned 70 ½. She would not be able to withdraw assets before the age of 59 ½ from the commingled IRA. If she elects the roll-over, her own account is not an inherited IRA. If she does not do the rollover, the inherited IRA is considered such. The spouse in that scenario would not have to withdraw money until the decedent spouse would have turned 70 ½ (or immediately assuming the spouse died after he or she reached 70 ½). Since now, under the SCOTUS decision, the inherited IRA would not be protected from bankruptcy, this new interpretation militates in favor of spouses rolling over the IRA into their own (or opening one post-haste if they did not have one to begin with). Naming a creditor-protection trust as a beneficiary is also an option for spouse and non-spouse inheritors alike. The trust will shield the inherited IRA funds from creditors, and can also control a (possibly spendthrift) heir to withdraw the funds in terms of timing and amount. Alison Arden Besunder is the founder of Arden Besunder P.C., a law firm focusing in the areas of trusts, estate planning, and surrogate’s court practice and litigation. She advises clients in Manhattan, Brooklyn, and Suffolk, Nassau and Queens Counties.

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