Clark v. Rameker: Inherited IRAs Are Not Protected from Creditors

Clients who have named a child or spouse with financial problems as the direct beneficiary of an IRA should reconsider their beneficiary designation. In June, the Supreme Court unanimously held that IRAs inherited from the original owner are not exempt from the bankruptcy estate. This means that if a holder of an inherited IRA files for bankruptcy, funds from the IRA will be accessible by a bankruptcy trustee to satisfy unpaid debts.

Section 522 of the Bankruptcy Code states that “an individual debtor may exempt from property of the estate [. . .] retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code.” This includes both traditional IRAs (section 408) and Roth IRAs (section 408A). Thus, when Heidi Heffron-Clark filed for Chapter 7 bankruptcy, she listed an IRA inherited from her mother as exempt property. The bankruptcy trustee disagreed, as did the Seventh Circuit. This case, Clark v. Rameker, affirmed the Seventh Circuit’s holding and resolved a conflict with the Fifth Circuit’s decision in In re Chilton, which had held that inherited IRAs did constitute exempt retirement funds.

The Court distinguished inherited IRAs from traditional and Roth IRAs in three ways. First, the holder of an inherited IRA cannot invest additional money in the account. Second, holders of inherited IRAs MUST withdraw from the accounts, regardless of proximity to retirement. Last, a person who holds an inherited IRA may withdraw all the funds at any time, without penalty.

The Court explained that the purpose of exempting retirement funds from the bankruptcy estate is to allow the debtor to meet his or her essential needs during retirement. Because funds in a traditional or Roth IRA are only accessible without penalty when the account holder reaches approximate retirement age, exempting these accounts comports with that goal. On the other hand, the holder of an inherited IRA can (and in fact, must) withdraw the funds over a prescribed time period, even if the person is many years away from retirement. As Justice Sotomayor pointed out,

“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.’”

This ruling means that inherited IRA funds are accessible by creditors in the bankruptcy context. Therefore, estate planners should counsel their clients with substantial retirement accounts not to name individuals with a history of insolvency in their beneficiary designations. A better option is to create a trust, which can be impenetrable to most types of creditors. Trusts can hold a variety of assets and can be designated as IRA beneficiaries. In addition, distributions to beneficiaries can be limited to prevent trust assets from being consumed by the creditors of an insolvent trust beneficiary.