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Supreme Court Holds Inherited IRAs Not Exempt from Bankruptcy Estate

The Bankruptcy Code permits an individual in bankruptcy to exempt from the bankrupt estate “retirement funds” in an individual retirement account (“IRA”) or certain other tax-advantaged vehicles. In a recent case, the U.S. Supreme Court considered whether the exemption extends to amounts held in an inherited IRA qualified for the exclusion and unanimously held that it does not.

Ms. C inherited an IRA when her mother died and elected to take the proceeds as monthly distributions, presumably over her life expectancy. Several years later, Ms. C and her husband filed a Chapter 7 bankruptcy petition and identified the inherited IRA as an exempt retirement fund. The bankruptcy trustee objected to the claimed exemption and the case went through the courts, with the Court of Appeals for the Seventh Circuit upholding the trustee’s objection. The Supreme Court took the case to resolve a conflict between the Seventh Circuit’s decision and an earlier decision in the Fifth Circuit.

In holding that an inherited IRA was not a retirement fund and, therefore, not exempt, the Court focused on three differences between inherited IRAs and other (traditional or Roth) IRAs. First, unlike the owner of a traditional or Roth IRA, the beneficiary of an inherited IRA may not put additional funds into the account. Second, regardless of her age the beneficiary of an inherited IRA is required to either: i) take the entire IRA within five years after the death of the owner or ii) take minimum distributions on an annual basis. Finally, the beneficiary of an inherited IRA may take the balance in the account at any time without penalty, whereas any distributions from a traditional or Roth IRA before the owner reaches age 59½ will normally incur a 10% federal tax penalty.

The Court found its holding that an inherited IRA is not a retirement fund consistent with the Bankruptcy Code’s “careful balance between the interests of creditors and debtors.” Allowing debtors to exempt traditional and Roth IRAs helps ensure that they will be able to meet basic needs during retirement without creating a cash windfall to the detriment of creditors. Extending the exemption to inherited IRAs, however, would not prevent or even discourage beneficiaries from using the funds to make significant non-essential expenditures once the bankruptcy proceedings are complete.

Note: A beneficiary who inherits his deceased spouse’s IRA may roll the inherited IRA over into his own new or existing IRA. If such a rollover is made, the rules applicable to ordinary traditional or Roth IRAs, including the bankruptcy exemption, should apply.

Note 2: Because §401(k) plans are subject to the same distribution rules that apply to inherited IRAs, the bankruptcy exemption presumably would not apply to a non-spouse beneficiary of a decedent’s §401(k) plan account.

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