In Part I of this article the history of the recent US Supreme Court case, Clark v. Rameker, was described. Heidi Heffron-Clark had inherited an IRA from her mother. After Heidi and her husband filed for bankruptcy, the issue as to whether an inherited IRA can be protected in bankruptcy arose. After various appeals on this issue from the Bankruptcy Court up to the Seventh Circuit Court of Appeals, the US Supreme Court agreed to hear the case because of split among the Circuits. In its unanimous decision, the US Supreme Court determined that inherited IRAs are not protected in bankruptcy because they are not “retirement funds.”
The Court began its review by noting that the Bankruptcy Code does not provide a definition of “retirement funds.” Using the ordinary meaning of the term, the Court stated that “retirement funds” refers to money that is set aside for the time that a person is no longer working. The determination of whether funds held in an account are “retirement funds” should be based on the legal characteristics of the account holding the funds and on whether the account is one that was set aside for when an individual is no longer working.
The Court stated that there were three legal characteristics of inherited IRAs that made funds held in these accounts “not objectively set aside for the purpose of retirement.”
First, said the Court, IRC section 219(d)(4) prevents holders of inherited IRAs from putting additional funds into the account. Thus, where traditional and Roth IRAs allow their account holders to add to their retirement savings over time, inherited IRAs prohibit contributions to the account.
Second, holders of inherited IRAs must withdraw money from such accounts, without regard to the number of years until the account holder reaches retirement. That the tax rules governing inherited IRAs require that the accounts be depleted over time, regardless of how close their holders are to retirement, said the Court, is not a feature of an account set aside for retirement.
Third, inherited IRA owners may make penalty-free withdrawals from the account at any time, up to the entire balance of the account, without triggering the 10% early withdrawal penalty under IRC section 72(t). In contrast, withdrawals from a traditional or Roth IRA before the account holder reaches age 59 ½ are subject to the early withdrawal penalty, unless one of several limited exceptions apply. Thus, funds held in inherited IRAs can be used for current consumption, while those in traditional and Roth IRAs cannot.
Fresh Start v. Free Pass.
According to the Court, the exemptions provided by the Bankruptcy Code create a balance between the rights of creditors and the needs of debtors. Allowing debtors to protect funds held in traditional and Roth IRAs aligns with this balance by helping to ensure that debtors will be able to meet their basic needs during retirement. At the same time, the limits on traditional and Roth IRAs help make sure that the debtors who hold these accounts (but who have not yet reached age 59 ½) do not enjoy a windfall due to the exemption.
By contrast, nothing about an inherited IRA’s legal characteristics prevents or discourages an individual from using the entire balance immediately after bankruptcy for purposes of current consumption. Allowing the exemption for inherited IRAs, said the Court, would turn the Bankruptcy Code’s “fresh start” into a “free pass.”
Change in status from regular IRA to inherited IRA.
The Clarks further argued that, because the funds in an inherited IRA were once set aside for retirement of the initial IRA owner, the funds continued to have the legal characteristics of funds set aside for retirement even after the original owner’s death. That is, the death of the initial IRA holder would not in any way affect the funds in the account. In response, however, calling this a “backward-looking inquiry”, the Court said that the ordinary use of the term “retirement funds” implied that the funds were currently in an account set aside for retirement, not that they were set aside for retirement at some point in the past.
In order to avoid the result that the Clarks had in this case, an IRA owner should consider establishing a trust for the beneficiary or beneficiaries. These trusts are sometimes referred to as IRA Beneficiary Trusts or IRA Standalone Trusts. Once the trust is established, the IRA owner, instead of listing the individuals personally on the beneficiary designation form, would list the IRA Beneficiary Trust. However, if there is more than one beneficiary of the IRA Beneficiary Trust, then the separate subtrust for each beneficiary would be listed on the beneficiary designation form. In this way each beneficiary would be able to use his or her own life expectancy in determining the required minimum distributions that would have to be taken each year.