Inherited Individual Retirement Account (IRA) Are Not Protected Assets in Bankruptcy
The U.S. Supreme Court has just ruled, in a case titled Clark v. Rameker, that funds in an inherited IRA are not protected in bankruptcy. The case centered on an IRA fund that Heidi Heffron-Clark inherited, as the sole beneficiary, from her mother in 2001. Heffron-Clark filed for Chapter 7 bankruptcy nine years later and, when the bankruptcy trustee went after the funds to cover the outstanding debts, Heffron-Clark tried to argue that IRA inheritance funds should not be available to creditors because it was "retirement funds." The bankruptcy court disagreed. On appeal, the U.S. District Court for the Western District of Wisconsin reversed the lower court's decision, only to be overturned by the 7th Circuit U.S. Court of Appeals. The U.S. Supreme Court affirmed the Court of Appeals decision, unanimously finding the funds were not worthy of bankruptcy protection.
According to the Court, traditional IRAs warrant protection during bankruptcy because the purpose of them is to encourage people to save for the future - specifically, retirement. In conjunction with this purpose, owners of traditional IRAs are subject to withdrawal restrictions and cannot use the money at any time they choose. Beneficiaries of inherited IRAs, on the other hand, can cash in an IRA at any point. As Justice Sotomayor pointed out, "Nothing about the inherited IRA's legal characteristics would prevent (or even discourage) the individual from using the balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete."
It appears as though the Court's holding is based on the language of Section 522 of the Federal Bankruptcy statutes. Several states have their own bankruptcy statutes (and exemptions) and do not follow the Federal statutes verbatim. Thus, as of now, the holding inRameker may or may not apply to one's IRA funds and a thorough examination of applicable state law is required on an individual basis.
This is an important decision, nonetheless. Baby boomers and others who are leaving behind unspent IRA accounts should consider the use of IRA beneficiary trusts, which can be drafted as Spendthrift trusts and thus providing a level of protection for the IRA asset during the time it is held in trust. As with any asset protection plan, there are numerous legal ramifications and regulations that should be considered before taking action.