The Bell Tolls for Inherited IRAs

Posted by on Jul 1, 2014 in Uncategorized | Comments Off on The Bell Tolls for Inherited IRAs

In a unanimous decision authored by Justice Sotomayor, the Supreme Court found that “[t]he text and purpose of the Bankruptcy Code make clear that funds held in inherited IRAs are not ‘retirement funds’ within the meaning of §522(b)(3)(C)’s bankruptcy exemption.” Clark v. Rameker (In re Clark), No. 13-299 (U.S.S.Ct. June 12, 2014).

The opinion focused on differences in treatment under the Tax Code between inherited IRAs which go to a surviving spouse, and those that go to someone other than the spouse. A spouse has the option of rolling over the funds into a new IRA, treated like any other IRA, but a non-spouse is limited to treating the funds according to rules applicable only to inherited IRAs. The latter type differs from regular IRAs in that funds must be withdrawn either in their entirety or in annual distributions; the heir may not make contributions to the fund, a factor the Court found to be a hallmark of a retirement account; and withdrawal of the funds does not give rise to tax penalty.

The Court rejected the argument that the nature of the funds should be determined with reference to their original purpose. “Instead, we look to the legal characteristics of the account in which the funds are held, asking whether, as an objective matter, the account is one set aside for the day when an individual stops working.” 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.  “[N]othing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.”

The Supreme Court took this case because there was disagreement among federal appellate courts on the issue. Federal law encourages saving for retirement by protecting “retirement funds” from creditors in bankruptcy.  Generally speaking, a person can file bankruptcy and have his or her debts discharged, while leaving an IRA or other similar retirement assets owned by the debtor intact for the debtor’s retirement.  The Court had to decide whether this exemption for retirement funds should also extend to IRAs inherited from another person, which did not represent the debtor’s own savings. The Court noted three important distinctions between an inherited IRA account and other more traditional retirement assets:  (1) Holders of an inherited IRA account cannot add additional assets; (2) Holders of an inherited IRA account are required to withdraw monies from the account regardless of whether they have reached retirement age; and (3) Holders of an inherited IRA account may withdraw assets from the account at any time, without an income tax penalty. Based on these three distinctions, the Court ruled that persons who file bankruptcy may not use the federal exemption provisions to protect inherited IRAs from their creditors. This ruling does mean that, going forward, inherited IRAs have fewer creditor protection characteristics.  The decision does not mean that creditor protection is unavailable for inherited IRAs.  Inherited IRAs can still likely be protected from creditors by at least two different means: (1) State law creditor exemptions; and (2) Leaving IRAs in trust for the intended beneficiary, rather than to the beneficiary himself/herself.

As to the first option (state law creditor exemptions), it appears that states opting out of the federal bankruptcy exemptions in favor of their own state-created exemptions may still create exemptions for inherited IRAs.  The Clark decision only addressed the federal exemptions in non-opt out states.  Currently, a limited number of states have such exemptions in place to cover inherited IRAs, including Florida, Alaska, Missouri, North Carolina, Texas, and our own state of Ohio (effective in early 2013).

In March of 2013 the Ohio legislature passed the Ohio Legacy Trust Act (H.B. 479) (the “Act”) which, in addition to providing rules for the creation of what may be known as legacy trusts, also amended several provision of Ohio law that are important in bankruptcy cases.

The Act also made changes to Ohio’s Exemption statute 2329.66 that also will impact bankruptcy practice. First, exemptions now will only index upward based upon the CPI. Before, exemptions would change based upon changes in CPI. Now, exemptions will only change based upon increases in CPI.

The most significant change; however, is the increase of the homestead exemption from $20,200 to $132,600.1 The Act also provides that the exemption does not impair liens for taxes or obligations owed to the State of Ohio or any agency or political subdivision instead of just taxes owed on the property.

Other changes to the exemption statute involve retirement accounts changing language from a person’s “right to receive” to a person’s “right to receive or interest in receiving” payments.

Expands the current exemption for certain payments under any individual retirement account, individual retirement annuity, “Roth IRA,” or education individual retirement account to include an exemption for certain payments or benefits under a “529 plan.” Including inherited IRA’s.

Exempts a person’s rights or interests in assets held in, or to receive any payment or benefit under, any individual retirement account, individual retirement annuity, “Roth IRA,” “529 plan,” or education individual retirement account that a decedent, upon or by reason of the decedent’s death, directly or indirectly left to or for the benefit of the person outright or in trust or otherwise

(e) The person’s rights to or interests in any assets held in, or to directly or indirectly receive any payment or benefit under, any individual retirement account, individual retirement annuity, “Roth IRA,” “529 plan,” or education individual retirement account that a decedent, upon or by reason of the decedent’s death, directly or indirectly left to or for the benefit of the person, either outright or in trust or otherwise, including, but not limited to, any of those rights or interests in assets or to receive payments or benefits that were transferred, conveyed, or otherwise transmitted by the decedent by means of a will, trust, exercise of a power of appointment, beneficiary designation, transfer or payment on death designation, or any other method or procedure.

When dealing with certain assets and exemptions it is always important to consult with experienced bankruptcy counsel like Thomas, Trattner & Malone, LLC.