There are very few assets we own that are more sacred than our retirement plans. Under general legal principles and public policy, most jurisdictions exempt retirement accounts, such as 401Ks and IRAs, from creditors. However, in a recent court case, the so-called “inherited IRA,” was held not to have such “firewall” creditor protection.
An inherited IRA is nothing more than an IRA that is passed from the owner of an IRA at his or her death to the designated beneficiary. In general, sound public policy supports the stance that because retirement accounts are so critical to one’s financial resolve in later life, those assets should be inaccessible by creditors should any liability arise. It was therefore not hard to follow that one could give away the remaining assets of an IRA account, at which point the beneficiary would obtain the assets in the same form as they existed previously, that is to say, exempt from potential judgment creditors.
However, on April 23 of this year, the Seventh Circuit Court of the United States Court of Appeals held that these inherited IRAs are not exempt in a debtor-beneficiary’s bankruptcy proceeding. Because this is the first time such a result has occurred, there now exists a split in authority between the Circuit Courts, therefore making it possible that the United States Supreme Court could ultimately decide to resolve the issue, and this could go either way. Regardless of whether the Supreme Court decides to give their opinion, this split in authority should raise serious doubt to those who may have been relying on the inherited IRA to provide their children or other non-spousal-beneficiaries with assets that are protected from such creditors.
In re Nessa
In the 2010 case of In re Nessa, the Eighth Circuit Bankruptcy Appellate Panel ruled on whether an IRA that a debtor inherited from her father qualified as exempt under the Bankruptcy Code. Section 522(d)(12) of the Bankruptcy Code states that 1) retirement funds, that are 2) exempt from taxation under one of the provisions of the IRC (including IRAs under Section 408) are exempt from the bankruptcy estate in the case of bankruptcy proceedings. The Court, applying this code section, determined that because the debtor-beneficiary’s father’s account existed as an IRA (as defined under section 408(a)), it became an “inherited individual retirement account” upon on her father’s passing.
The two main issues were, 1) whether the inherited IRA could be classified as a “retirement fund,” under Section 522(d)(12), and 2) whether different distribution rules between an IRA and an inherited IRA in fact prevented the inherited IRA from being regarded as an IRA recognized under the Bankruptcy code section. In regard to the first issue, not wanting to “limit the statute beyond its plain language,” the Court noted that Section 522(d)(12) did not specify that a retirement fund must be established by any particular individual, but only that it exists as a retirement fund generally. The Court then turned to issue #2, and pointed out that any differences between the rules of distribution between an IRA and an inherited IRA were irrelevant, again highlighting the broadly encompassing language of Section 408(e)(1), “any individual retirement account is exempt from taxation.”
In conclusion, the direct transfer from the father’s IRA account to the beneficiary-daughter’s inherited IRA account did not remove those assets from the exempt status provided by the Bankruptcy Code, and the assets were still, then, exempt from the bankruptcy estate.
In re Chilton
In March of 2012, the United States Court of Appeals for the Eight Circuit reached the same conclusion in the case of In re Chilton. The facts were very similar to the case above, and here, a daughter inherited an IRA from her deceased parent, set up an IRA account to receive distributions from her mother’s IRA, and subsequently filed for bankruptcy. The daughter attempted to remove the inherited IRA from the bankruptcy estate per the above mentioned Bankruptcy Code Section 522(d)(12), and contentions regarding whether the funds in the inherited IRA were “retirement funds” ensued. The Court here, just like above, discussed the two requirements of Section 522(d)(12), namely 1) whether there existed a retirement account, and 2) whether that account was exempt from tax under Section 408.
The Court held that funds in an inherited IRA are indeed retirement funds, regardless of the fact that they originally belonged to the mother. Similar to In re Nessa, the Court did not want to diverge from the plain meaning of the statutory language of what a “retirement fund” meant. The court did note, however, that a basic component of a retirement fund is that it is “set apart” for retirement, and what happens after those funds are “set apart” should be of no matter. Further, the Court held that these funds complied with the second part of the test, namely, that they were in a fund/account that was exempt from taxation under Section 408. Like the Eighth Circuit, the Court pointed to the expansive language of Section 408(e), which states, “any individual retirement account is exempt from taxation under this subsection…,” and stated that even though distribution rules differed between inherited IRAs and IRAs, the definition provided in the code for “individual retirement accounts” encompassed both.
Because the inherited IRA had once again met both tests, it was therefore held to be exempt from the bankruptcy estate under Bankruptcy Code Section 522(d)(12).
In re Clark
Then, on April 23, 2013, Seventh Circuit of the United States Court of Appeals issued its holding on the case of In re Clark, thereby providing a direct contradiction to what seemed to be a trend in protecting inherited IRAs from bankruptcy creditors. The Court raised the two element issue once again, and began by confirming that both 1) an IRA in which a person provides for his or herown retirement, and 2) an IRA that is inherited by the spouse of such an individual, meets the requirements of Bankruptcy Code Section 522(d)(12). Such an IRA, the Court stated, is a “retirement fund,” because the surviving spouse is under the same distribution restrictions as the deceased.
However, the Court then turned its attention to non-spousal beneficiaries of inherited IRAS, and held that these accounts should not be classified as retirement accounts, as they are held by individuals that are afforded different distribution rules than the original owners of the IRA. Such differences include: the beneficiary of the IRA cannot make new contributions, cannot roll over the balance or merge it with another account, the inherited IRA must begin distributing assets within a year of the original owner’s death (vs. being dedicated to the beneficiary’s retirement years), and lastly, the inherited IRA payout must be completed in as little as five years. While the Court was very aware of other Circuit Courts, it refused to subscribe to the principle that retirement funds in the decedent’s hands must be treated the same way in the successor’s hands. Instead, the Court pronounced that the original nature of the IRA as “retirement fund” was extinguished upon the parent’s death. To hold otherwise, the Court noted, “would be to shelter from creditors a pot of money that can be freely used for current consumption.” Therefore, the debtor-beneficiary daughter was unable to exempt the inherited IRA assets from the bankruptcy estate.
What this means to you
If you have an IRA, and were under the impression that by designating your children or other non-spousal individuals as beneficiaries you were providing them assets with a degree of creditor protection, you would be wise to plan ahead. It is imperative you meet with your estate planning lawyer or your retirement plan administrator and consider the various beneficiary designation options that do not place the benefits directly into the hands of your designated beneficiaries. One such option is to create a spendthrift trust in the state of Nevada or one of the other asset protection jurisdictions established for the benefit of your descendents, and designate this Trust as the account beneficiary at your death. This will place the most protective “firewalls” around what is often the largest single asset of the deceased and provide the protective shield for this asset class.
We hope you find this information helpful. If you wish to schedule a free consultation to discuss this or any other related topic, please do not hesitate to contact us.