Bankruptcy Law: Inherited IRAs aren't exempt as "retirement funds"

When individuals file for bankruptcy protection, they are permitted to exempt certain categories of assets from their bankruptcy estate, thereby removing those assets from the potential reach of the estate's creditors. One category of exempt assets includes certain "retirement funds." 11 U.S.C. Sec. 522(b)(3)(C). The question before the U.S. Supreme Court in Clark v. Rameker was whether or not funds contained in an inherited IRA qualify as "retirement funds" for purposes of the exemption. The Court held that they do not, as they are fundamentally different in character than traditional retirement funds.

The Court reviewed the different types of IRAs permitted under Federal law: traditional IRAs, Roth IRAs, and inherited IRAs. The first two types offer tax advantages to encourage individuals to save for retirement -- qualified contributions to traditional IRAs are tax deductible, while qualified distributions from Roth IRAs are tax free. To ensure that the money is actually set aside to be used for retirement, certain withdrawals from both types of accounts before age 59 1/2 are subject to a 10% penalty. Individuals who inherit an IRA after the owner's death have a choice of either rolling the IRA over into their own IRA (if their spouse was the owner), or holding it as an inherited account.

Inherited IRAs operate differently than traditional or Roth IRAs. For example, individuals may withdraw funds from them at any time, without paying a tax penalty. In fact, they must withdraw its funds, either completely within 5 years of the original owner's death, or through annual minimum distributions. Furthermore, the owner of an inherited IRA can never make any contributions to the account.

In this case, the decedent named her daughter as the sole beneficiary of her IRA, and when the owner passed away the following year it was worth about $450,000. The daughter elected to take monthly distributions from the inherited IRA. Nine years later she filed for Chapter 7 bankruptcy protection, and she sought to exclude the IRA (now worth about $300,000) from the estate. The bankruptcy trusteee and unsecured creditors objected to the claimed exemption on the grounds that the funds in the inherited IRA were not "retirement funds" under the law. The Bankruptcy Court agreed, but was reversed by the District Court, which held that the exemption covered any funds originally accumulated for retirement purposes. The Seventh Circuit reversed the District Court, pointing to the different rules governing inherited IRAs, and stating that "inherited IRAs represent an opportunity for current consumption, not a fund for retirement savings."

The Supreme Court agreed, holding that the term "retirement funds" is properly understood to mean sums of money set aside for the day an individual stops working. The Court concluded that because the holder may never invest any further money into the account, and because they are required to withdraw money from them regardless of how many years they are from retirement, and because they may withdraw some or all of the money at any time and for any purpose without penalty, such inherited IRAs are not truly "retirement funds" as defined in the law. Instead, they are pots of money that can be freely used for current consumption, not funds objectively set aside for one's retirement, even if that's how the new owner chooses to use them. The proposed exemption was therefore disallowed.