When is an IRA not a “retirement” account?
The U.S. Supreme Court answered that riddle today and resolved a key question that has lingered for nearly a decade: Are funds in an inherited IRA protected in bankruptcy? The answer was a unanimous, “No.”
In an opinion with far-reaching implications, written by Justice Sonia Sotomayor, the Court found that Heidi Heffron-Clark, who inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later, could not shield the account from her creditors. Clark v. Rameker.
The Court’s analysis turned on key legal distinctions between inherited IRAs and those that you set up and fund yourself, either through annual contributions or by rolling over assets from a company plan.
Several features make inherited IRAs unique and suggest that they are not retirement assets, the Court noted. Unlike IRA owners, inheritors can’t put additional funds into the account, and they can take out money at any time without penalty. In fact, generally, non-spousal IRA heirs must either withdraw the entire account balance within five years of the original owner’s death, or take out a minimum amount each year, starting by Dec. 31 of the year after the IRA owner died. Note: This is true whether it’s a traditional IRA or a Roth (a common misconception). See my post, “Inherited IRA Rules: What You Need To Know.”
This whole system is different from the one that applies to IRA owners, which is designed to ensure that they will have money available during retirement, and therefore justifies protection of those assets during bankruptcy, the Court noted.
Money in IRA accounts (or employer sponsored retirement plans, such as 401(k)s and 403(b)s) will not normally be covered by a will. Instead, an IRA inheritance is given out according to beneficiary designation forms that you fill out when you open the accounts or later amend. On such a form, which she completed in 2000, Ruth Heffron made her daughter the sole beneficiary of the account. It was worth just over $450,000 when she died the following year.
Heffron-Clark had drawn the account down to roughly $300,000 by the time she filed a Chapter 7 bankruptcy petition in October 2010. At that point she tried to argue that money in the account should not be available to her creditors because it was “retirement funds.” The creditors objected and the bankruptcy court agreed with them. On appeal, the U.S. District Court for the Western District of Wisconsin reversed that decision, only to be overturned by the 7th Circuit U.S. Court of Appeals.
One interesting aside is that all this litigation, during the past four years, would seem to involve a lot of legal bills for someone who was supposedly in financial duress. Another is the practical strategies that IRA inheritors might want to consider in light of the Court’s decision.
Most notably the decision has important ramifications for spouses. A spouse who inherits–let’s assume it’s the wife–has an option not available to other inheritors. She can roll the assets into her own IRA and postpone distributions from a traditional IRA until she turns 70½. The catch is, like other IRA owners she may have to pay a 10% early-withdrawal penalty if she takes money before age 59½ from her own IRA, as explained here.
Unless she does the rollover, however, the account is considered an inherited IRA. She would not have to take any money out until her late spouse would have turned 70½. But under today’s decision those assets would not seem to be protected in bankruptcy. So spouses now have one more reason, in addition to income tax benefits, to do a rollover.
Another workaround, which can be used to benefit a spouse or anyone else, is to name a trust, rather than a person, as the beneficiary of an IRA, says Gideon Rothschild, a lawyer with Moses & Singer in New York. Even before today’s decision, that was a popular strategy to protect IRA assets from creditors. However, complex rules govern this approach and pitfalls abound. So don’t do this without help from advisors who are experts in the field.
Today’s decision does not affect bankruptcy protection for retirement accounts of your own, which were expanded or strengthened by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. But it does interpret a key ambiguity in the law that has been debated ever since it took effect.
Archive of Forbes Articles By Deborah Jacobs
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.