It has always been a given that IRAs are exempt from creditor claims. Not so fast….. A recent Supreme Court case carves out an exception to this general rule for IRAs inherited from a decedent.
By way of background, there are several species of IRAs. The most common is the traditional IRA created by the owner. An important cousin is the inherited IRA, which is an IRA received from a decedent. An inherited IRA confers valuable tax benefits, namely that the beneficiary may stagger withdrawals (known as required minimum distributions) over the beneficiary’s life expectancy. This feature can be used to defer income taxes into post-retirement years with lower marginal tax rates. Alternatively, the beneficiary can always take larger distributions when needed. Unlike traditional or Roth IRAs, however, an inherited IRA is fair game for creditors to reach if the beneficiary files for bankruptcy.
In Clark v. Rameker, 134 S.Ct. 2242 (2014), the Supreme Court ruled that an inherited IRA is part of the bankruptcy estate subject to creditor claims. The taxpayer filed for Chapter 7 bankruptcy in 2010 and listed an inherited IRA (received back in 2001) as an exempt asset. The focus was on Section 522(b)(3)(C) of the Bankruptcy Code, which exempts “retirement funds” from the bankruptcy estate. The court noted several key differences between inherited and traditional IRAs. In particular, the holder of an inherited IRA (i) may not invest additional funds, (ii) must take required minimum distributions no matter how far away from retirement, and (iii) may withdraw the entire balance at any time (even to purchase a vacation home or sports car) without the 10% penalty. Primarily because of these distinctions, the court held that inherited IRAs are not “retirement funds,” and are not exempt from the bankruptcy estate. The fallout from Rameker continues. Some commentators believe Rameker might be extended to spousal rollovers.
In all events, practitioners should consider Rameker before making the usual recommendation that clients name their children (rather than trusts for their benefit) as inherited IRA beneficiaries.