A federal court of appeals has determined that money in inherited individual retirement accounts is not protected from creditors by federal exemption laws.

Federal bankruptcy laws permit individuals to claim certain property as exempt from the reach of their creditors. Many types of retirement accounts and benefits are protected by these exemptions. “Inherited” Individual Retirement Accounts (IRAs) hold funds from persons who established IRAs for their own use and died before depleting the funds in those accounts. The Seventh Circuit Court of Appeals has concluded that funds in a non-spousal inherited individual retirement account are not exempt or protected from claims of the heir’s creditors. In re Heffron-Clark, 714 F.3d 559 (7^th Cir. 2013).

Judge Easterbrook’s opinion considered the exemptions under federal bankruptcy law, 11 U.S.C. §522(b)(3)(C) and (d)(12). Those provisions exempt from creditors’ claims any “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code of 1986.” An individual retirement account by which a person provides for his or her own retirement meets this requirement. If a married IRA holder dies, the decedent’s spouse inherits the account and the money remains “retirement funds” in the same sense as before the original owner’s death: there are limits on when withdrawals may occur without penalty, and requirements to start withdrawals when the account holder (original or surviving spouse) reaches a certain age.

Different rules govern inherited IRAs than “traditional” IRAs. While the funds in the inherited IRA account remain sheltered from tax until the money is withdrawn, other attributes of the account change. For example, no new contributions can be made, and the balance cannot be rolled over or merged with another account. Moreover, the funds are not dedicated to the heir’s retirement years. The inherited IRA must begin distributing its assets within a year of the original owner’s death, and payout must be completed (with limited exceptions) in as little as five years. According to the court, because the exemptions require that the account be both tax-exempt andretirement funds, and the money in an inherited IRA cannot be held in the account until the heir’s retirement, the inherited IRA does not fit the definition of the exemption set out in the Bankruptcy Code.

The Seventh Circuit’s decision is in contrast to the opinions in In re Nessa, 426 B.R. 312 (BAP 8^th Cir. 201) andIn re Chilton, 674 F.3d 486 (5^th Cir. 2012). The courts in those cases determined that inherited IRAs are exempt under the Bankruptcy Code because: (a) the exemption statutes merely require the funds to be “retirement funds” (as they were for the decedent), not the debtor’s retirement funds, and (b) while traditional and inherited IRAs may have different distribution rules, both are tax-exempt under 26 U.S.C. §408.