By Cyril Tuohy
A ruling by the U.S. Supreme Court holding that assets contained in an inherited individual retirement account (IRA) don’t qualify as retirement funds for the purposes of bankruptcy exemption, has turned the estate planning community on its head.
The Supreme Court’s ruling is “sending seismic shock waves through the estate planning community,” said Gail Buckner, a retirement and financial planning specialist and instructor with Franklin Templeton Investment.
In a story published on Fox Business, Buckner, citing sources with accounting, estate and wealth transfer expertise, said that the ruling will make it easier for creditors and bankruptcy attorneys to lay claim on inherited retirement assets.
In Clark V. Rameker, the Supreme Court on June 12 ruled 9-0 to uphold a lower court ruling in favor of bankruptcy trustee William J. Rameker.
“This decision points to a significant chunk of American wealth that is now, quite clearly, no longer as ‘bulletproof’ from creditors as most thought,” Eleanor Blayney, the Board of Certified Financial Planners’ consumer advocate, wrote in a recent blog posting.
IRAs held assets worth $6.5 trillion at the end of last year, according to the Investment Company Institute.
“Estimating non-spousal inherited IRAs at 1 percent of total IRA wealth, this could mean that $54 billion in IRA assets previously inaccessible to creditors are now no longer protected,” Blayney wrote. “It’s not a bad time to be a bankruptcy attorney!”
“In light of this decision, many are asking themselves: If inherited IRAs aren’t protected, how long before traditional and Roth IRAs aren’t protected either?” Blayney wrote.
The court didn’t address that question.
The question facing the Supreme Court was: Does the U.S. Bankruptcy Code exempt an inherited IRA from a debtor’s estate in bankruptcy?
“The crux of the decision came in the discussion of the purpose of bankruptcy and the court’s finding that, where Congress intended to protect retirement funds and the debtor could access the inherited funds prior to retirement, the inherited IRA smacked of windfall,” the National Consumer Bankruptcy Rights Center reported in a blog post.
Writing for the unanimous court, Justice Sonia Sotomayor held that an inherited IRA account did not qualify as a retirement fund, and was therefore not exempt.
“The text and purpose of the Bankruptcy Code make clear that funds held in inherited IRAs are not ‘retirement funds,’” within the meaning of the bankruptcy exemption, Justice Sotomayor wrote in her 11-page decision.
Inherited IRAs do not fit the definition of a retirement fund because the heir to the fund — other than a spouse — cannot invest more money or make contributions to the account.
The accountholder, or heir, is also required to draw money from the account in its entirely or via annual distributions, regardless of how many years the inherited IRA accountholder has until retirement. Taxes are paid on the distributions.
Allowing an inherited IRA to be exempt from creditor claims would ultimately undermine the purpose of the Bankruptcy Code, the Supreme Court found.
The case began in 2001, when Heidi Heffron-Clark inherited a $450,000 traditional IRA from the estate of her mother Ruth Heffron. Heffron, who died in 2001, had named her daughter the sole beneficiary of the account the year before.
Upon Heffron’s death, Heffron-Clark chose to take monthly distributions from the inherited account as required by law.
But when Heffron-Clark and her husband filed for Chapter 7 bankruptcy in 2010, the couple claimed the inherited IRA, now with a balance of only $300,000 due to the monthly distributions, was exempt from claims of the creditors.
Bankruptcy trustee William J. Rameker and unsecured creditors of the estate objected to the claimed exemption on the grounds that the funds in the inherited IRA were not retirement funds in the context of bankruptcy laws.
Heffron-Clark had been receiving monthly distributions from the account for almost a decade.
The Bankruptcy Court agreed with Rameker and the bankruptcy trustees. It concluded that funds in an inherited IRA are not “segregated to meet the needs of, nor distributed on the occasion, of, any person’s retirement.”
A U.S. District Court disagreed, however, and reversed the Bankruptcy Court’s ruling. The U.S. District Court found that the exemption covers any account containing funds “accumulated for retirement purposes.”
The opinion of the U.S. District Court was overturned by the 7th U.S. Circuit Court of Appeals. The circuit court concluded that “inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.”
The Supreme Court agreed with the circuit court. “We now affirm,” Justice Sotomayor wrote.
Will it remain the law of the land?
The National Consumer Bankruptcy Rights Center said since this case involved exemptions under federal law, it’s possible there may be some “wiggle room,” but only in states with “applicable exemptions that do not track the federal language.”
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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