In a landmark decision Thursday, the Supreme Court ruled unanimously, 9-0, that inherited IRAs are not protected in bankruptcy under federal law.
The decision has far reaching ramifications and, depending on your heirs' specific circumstances, may give you pause as to who — or what — is the best beneficiary for your retirement accounts.
A bit of background
In 2005 President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). While, on the whole, the law was designed to make filing for bankruptcy less appealing, it had a silver lining for retirement account owners. BAPCPA afforded a great deal of bankruptcy protection to "retirement funds," providing IRAs and Roth IRAs with a cumulative $1 million inflation-adjusted (currently $1,245,475) exemption and employer-sponsored plans with an unlimited exemption.
While that may seem fairly straightforward, the seemingly innocuous use of the phrase "retirement funds" in the bankruptcy statute muddied the waters. Bankruptcy trustees eventually began to challenge the exempt status of inherited IRAs, citing that they weren't "retirement funds" and thus, not protected in bankruptcy under the federal bankruptcy rules. For the past few years, various courts have weighed in on the issue, delivering anything but consistent decisions. Indeed, even the very case brought forth to the Supreme Court and decided Thursday, Clark v. Rameker, had its own roller coaster of a ride before reaching the High Court.
It started in 2010, when Heidi Heffron-Clark filed for Chapter 7 bankruptcy protection, but listed her inherited IRA, worth about $300,000 at the time, as an exempt asset (unavailable to creditors). The bankruptcy trustee and Clark's creditors objected to this exemption and the Wisconsin bankruptcy court which first heard the case agreed, ruling that Clark's inherited IRA wasn't protected in bankruptcy and was an available asset that could be used to satisfy her creditors. Clark appealed to a federal district court, which reversed the bankruptcy court's initial decision. Later however, the bankruptcy trustee appealed the district court's decision to the 7th Circuit Court of Appeals, which reversed the district court's decision — putting things back to where they had started — once again holding that Clark's inherited IRA wasn't protected.
Ultimately, with few other options, Clark appealed that decision to the Supreme Court, which brings us all the way to yesterday's big decision.
The Supreme Court's conundrum
In deciding the Clark case, the primary issue before the Supreme Court was whether or not an inherited IRA is a retirement account. At first glance, that might seem crazy. After all, an inherited IRA is an inherited individual retirement account. It says retirement in the name. That said, there were, in fact, some very fair arguments to be made on both sides of the coin.
On the one hand, if someone owns a house, and that house is left to their child, would anyone argue that it isn't a house anymore? Why should an IRA be any different? If it was a retirement account for the original owner — which no one would dispute — then why should its character change merely because the owner dies?
On the other hand, there are a number of reasons why an inherited IRA should not be considered a "retirement" account and ultimately, the Supreme Court felt these factors outweighed their counterparts. Specifically, the Supreme Court felt the following characteristics of inherited IRAs weren't characteristics of a "retirement" account:
*Beneficiaries cannot add money to inherited IRAs like IRA owners can to their own accounts.
*Beneficiaries of inherited IRAs must generally begin to take RMDs in the year after they inherit the account, regardless of how far away they are from retirement. For instance, a grandchild that inherits an IRA at one-year old must begin taking RMDs by the time they are two. It's hard to see how that can be for their retirement.
*Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty. IRA owners must generally wait until 59 ½ before they can take penalty-free distributions.
Relying largely on these items, the Supreme Court decided that inherited IRAs don't contain "retirement funds" and, as a result, the favorable bankruptcy protection afforded to such funds under the federal bankruptcy code should not be extended to them.
Does this decision apply to all inherited IRAs?
Although the Supreme Court's decision doesn't explicitly state one way or another, its ruling seems to be limited to IRAs inherited by someone other than a spouse. There are a number of special rules for spousal beneficiaries under the tax code, including the ability for a surviving spouse to rollover a decedent's IRA into their own IRA. In fact, during oral arguments, the bankruptcy trustee's attorney even made a point to distinguish Clark's inherited IRA from that of a surviving spouse.