Why Inherited IRAs Aren't Protected in Bankruptcy

A unanimous Supreme Court held that the funds in an inherited IRA do not qualify for exemption in bankruptcy because they do not share the same characteristics of "retirement funds" that traditional IRAs have.  

In 2000, Ruth Heffron established a traditional IRA and named her daughter, Heidi Heffron-Clark, as the sole beneficiary. When Ms. Heffron died the next year, the IRA, worth at the time about $450,000, passed to Heidi as an inherited IRA. Heidi elected to take monthly distributions from the account.

In October 2010, Heidi and her husband filed a Chapter 7 bankruptcy petition. They identified the inherited IRA, by then worth around $300,000, as exempt from the bankruptcy estate under 11 U.S. C. section 522(b)(3)(C). The bankruptcy trustee and the unsecured creditors of the estate objected on the ground that the funds in the inherited IRA were not “retirement funds” within the meaning of the statute. The Bankruptcy Court agreed, concluding that an inherited IRA does not contain anyone’s retirement funds, since, unlike traditional IRAs, the funds are not segregated to meet the needs of any person’s retirement.

The District Court reversed the Bankruptcy Court, and the Seventh Circuit reversed the District Court. The Supreme Court granted certiorari to resolve a conflict between the Seventh Circuit and the Fifth Circuit.

In her written opinion on the case, Clark v. Rameker, Justice Sonia Sotomayor said that 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 Section 522(b)(3)(C) bankruptcy exemption.

“Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement,” she stated. “First, the holder of an inherited IRA may never invest additional money in the account. Inherited IRAs are thus unlike traditional and Roth IRAs, both of which are quintessential ‘retirement funds.”

“Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement. Finally, the holder of an inherited IRA may withdraw the entire balance of the account at any time—and for any purpose —without penalty. Whereas a withdrawal from a traditional or Roth IRA prior to the age of 59 1/2 triggers a 10 percent tax penalty subject to narrow exceptions—a rule that encourages individuals to leave such funds untouched until retirement age—there is no similar limit on the holder of an inherited IRA.”

Sotomayor observed that as a general matter, “the provisions of the Bankruptcy Code’s exemption provisions effectuate a careful balance between the interests of creditors and debtors.”
Exemptions serve the important purpose of protecting the debtor’s essential needs. While allowing debtors to protect funds held in traditional and Roth IRAs comports with this purpose by helping to ensure that debtors will be able to meet their basic needs during their retirement years, the same cannot be said of an inherited IRA, she indicated.

“For if an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing 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,” she wrote. “Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a ‘fresh start,’ into a ‘free pass.’ We decline to read the retirement funds provision in that manner.”

Roger Russell is a tax attorney and a legal and accounting journalist with expertise across a wide spectrum of tax, legal and accounting issues.

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