Supreme Court Rules Inherited IRA Funds Not Exempt In Bankruptcy

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1 Supreme Court Rules Inherited IRA Funds Not Exempt In Bankruptcy Alson R. Martin Lathrop & Gage LLP Mastin Boulevard Suite 1000 Overland Park, KS Tel: (913) Mobile: (913) Fax: (913) Bankruptcy Code 11 U.S.C. 522(b)(3)(C) exempts from the bankruptcy estate retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of The US Supreme Court in Clark v. Rameker (June 12, 2014) unanimously ruled in an opinion by Justice Sotomayor that the phrase retirement funds does not include an inherited IRA, in this case an IRA where the IRA owner s daughter was the beneficiary. The Court ruled that inherited IRA funds are not retirement funds and therefore not exempt in bankruptcy for three reasons. First, the holder of an inherited IRA may never invest additional money in the account. IRC 219(d)(4). Second, holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. IRC 408(a)(6), 401(a)(9)(B). Finally, the holder of an inherited IRA may withdraw the entire balance of the account at any time, and use it for any purpose, without a 10% premature distribution penalty. IRC 72(t)(2)(A)(ii). The case involves a daughter s inherited IRA of a daughter and not that of a surviving spouse. The opinion implies that the surviving spouse s rollover IRA is the person s own IRA and thus exempt in bankruptcy but, if the surviving spouse does not rollover, then the IRA is an inherited IRA and subject to the same rules as an inherited IRA of a non-spouse beneficiary. The opinion says no more on that subject and does not address whether a surviving spouse s rollover IRA is comprised of retirement funds or whether the surviving spouse s inherited IRA does not have retirement funds. Since the funds would be the same in either case, that would be a difficult distinction. The opinion implies that if a surviving spouse does not rollover an IRA and thus does not make it his/her own IRA, the result would be the same as the daughter s inherited IRA, as the IRA that is not rolled over by a surviving spouse is also an inherited IRA. The Court states: If the heir is the owner s spouse, as is often the case, the spouse has a choice: He or she may roll over the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA (subject to the rules discussed below). Section 408(d)(3), which deals with rollover contributions, says that an IRA shall be treated as inherited if -- (I) the individual for whose benefit the account or annuity is maintained acquired such account by reason of the death of another individual and (II) such individual was not the surviving spouse of such other individual. The availability of non-spouse beneficiary rollover 1

2 means the distributions from that inherited IRA can be extended over the beneficiary s life expectancy. The inherited IRA distribution period is the life expectancy of the beneficiary. Footnote 1 of the decision indicates that the result is the same whether the debtor uses state or federal bankruptcy exemptions. It states: Under 522, debtors may elect to claim exemptions either under federal law, see 522(b)(2), or state law, see 522(b)(3). Both tracks permit debtors to exempt retirement funds. See 522(b)(3)(C) (retirement funds exemption for debtors proceeding under state law); 522(d)(12) (identical exemption for debtors proceeding under federal law). Petitioners elected to proceed under state law, so we refer to 522(b)(3)(C) throughout. The Court stated: 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. 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, Rousey, 544 U. S., at 325, into a free pass, Schwab, 560 U. S., at 791. We decline to read the retirement funds provision in that manner. A Spouse Who Rolls Over Funds To Surviving Spouse s Own IRA Does Not Have Inherited IRA. A spouse beneficiary who inherits his deceased spouse s IRA may roll the inherited IRA over into the spouse s own rollover IRA. Reg , Q&A 5. If such a rollover is made, the rules applicable to ordinary traditional or Roth IRAs, including the bankruptcy exemption, should apply. A nonspouse cannot rollover an inherited IRA to a qualified plan or another IRA. IRC 408(d)(3)(C). The Court in Clark states: "If the heir is the owner's spouse, as is often the case, the spouse has a choice: he or she may rollover the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA (subject to the rules discussed below)."... "When anyone other than the owner's spouse inherits the IRA, he or she may not rollover the funds; the only option is to hold the IRA as an inherited account." Since Clark involved a non-spouse beneficiary, its statements regarding spousal beneficiaries are not part of the case s holding. Nevertheless, while not clear, the Court seems to imply that an IRA rolled over by a spouse beneficiary will be treated as the spouse's IRA, rather than an inherited IRA, and such IRA will be an exempt asset. If the spouse chooses to treat the IRA as an inherited IRA, however, it will not be an exempt asset. Fraudulent Transfer Issue. Could the rollover of an inherited IRA into the spouse s own IRA now be considered a fraudulent transfer under applicable state law? In Gilchinsky v. Westminster Bank, 311 N.J. Super. 339 (App. Div. 1998), the trial court rules yes but the appeals court reversed, stating that a fraudulent transfer requires a transfer to a third person, and a rollover from a qualified plan to an IRA is not a transfer to a third person. On the other hand, In re Pulliam, 279 B.R. 916 (Bankr. M.D. Ga. 2002) ruled that where a debtor withdrew funds from IRA with intent to pay creditors but then, after advice of lawyer that IRA funds were exempt property, debtor re-deposited funds into IRA, the rollover qualified as transfer because made with actual intent to hinder, delay, or defraud creditors. Further, a conversion of a regular to a Roth IRA that eliminates required minimum distributions (RMDs) could be found to be a fraudulent transfer or conversion, as least with respect to the RMD amount. 2

3 Cases Where State Law Exempts Inherited IRAs Should Have Different Result If State Exemptions Claimed In Bankruptcy. 11 USC section 522(b)(3)(C) provides an exception to the anti-stacking clause of 11 USC section 522(b)(1). The effect is that a debtor gets both the federal and state law exemptions with respect to retirement plan assets. The state law exemptions still apply in addition to the bankruptcy code retirement asset exemption for opt-out states and debtors opting for state law exemptions. If a state exemption statute specifically exempts inherited IRAs, as several do, those exemptions should still apply if the state is an opt-out state and the debtor claims the state exemptions in bankruptcy. Remember that the state law involved is the state law where the beneficiary resides, not where the deceased debtor resided. State Inherited IRAs Exemptions. Alaska (Alaska Stat ), Arizona (Ariz. Rev. Stat (B)), Florida (Fla. Stat ), Idaho (Idaho Code ), Kansas (K.S.A not specific but provides that all plans and IRAs are conclusively presumed to be spendthrift trusts), New York (N.Y. C.P.L.R. 5205(c) like Kansas, conclusively presumed to be spendthrift trusts) Missouri (Mo. Rev. Stat ), North Carolina (N.C. Gen. Stat. 1C-1601(a)(9)), Ohio (Ohio Rev. Code (A)(10)), South Carolina (S.C. Code ), and Texas (Tex. Prop. Code ) have exemption statutes or favorable court decisions that specifically protect inherited IRAs under state bankruptcy exemptions for federal bankruptcy purposes. If the IRA beneficiary resides in one of these states, then the beneficiary can in and outside bankruptcy protect their inherited retirement funds by claiming the state exemption instead of the federal exemption. Cases Involving Inherited Qualified Plan Accounts Should Have Different Result If Funds Remain In Plan. Paterson v. Shumate, (S.Ct. (1992) is still good law. Thus, ERISA plans are excluded (not exempted) from the bankruptcy estate. However, owner-only plans are not Title I ERISA plans and, therefore, are not excluded from the estate. Nevertheless, owner-only plans are 401(a) qualified plans and exempt in bankruptcy under BAPCPA. An attorney representing a debtor with an inherited account in an ERISA Title I plan should argue that the plan is excluded from the bankruptcy estate so we never get to the analysis of whether it is exempt. A debtor with an inherited account in an owner-only plan, however, may be subject to the same analysis of Clark v. Rameker since it would be reviewed under the same provision (522(b)(3)(C) for opt-out states or 522(d)(12) under the federal scheme) and likely judged not be an asset in a retirement fund. Finally, once a beneficiary rolls over inherited plan funds into an inherited IRA, the IRA would be subject to the Clark v. Rameker analysis. Note that an inherited IRA cannot be rolled over to another IRA or qualified plan. IRC 408(d)(3)(C). Cases By Creditors Outside Bankruptcy May Have Different Result. Decisions outside bankruptcy by creditors against debtors in state courts reflect same general issues as in this case. However, many state exemption statues use different language than the Bankruptcy Code. For instance, the Kansas statute does not use the term retirement funds. KSA (b) states: Except as provided in subsection (c), any money or other assets payable to a participant or beneficiary from, or any interest of any participant or beneficiary in, a retirement plan which is qualified under sections 401(a), 403(a), 403(b), 408, 408A or 409 of the federal internal revenue code of 1986 and amendments thereto shall be exempt from any and all claims of creditors of the beneficiary or participant. Any such plan shall be conclusively presumed to be a spendthrift trust 3

4 under these statutes and the common law of the state. Regular and Roth IRAs, including inherited IRAs, are provided for in IRC 408 and 408A. Trust Option Where Beneficiary Likely Subject To Creditors Claims. While rollover IRAs can be used to spread distributions over many years, other strategies may be preferable, particularly when the beneficiary is vulnerable to creditors. Certain trusts can qualify as designated beneficiaries for retirement plans and IRAs, and these trusts can incorporate spendthrift provisions, which provide full asset protection. Moreover, the trust vehicle can ensure ongoing management and control over ultimate disposition, while allowing flexibility in distributing assets among individual beneficiaries. The best option for protecting an inherited IRA is to create a standalone retirement trust for the benefit of all of the intended IRA beneficiaries. A spendthrift trust is exempt in bankruptcy and protected from the beneficiary s creditors under state law. Properly drafted, this type of trust offers the following advantages: Protects the inherited IRA from each beneficiary s creditors. Insures that the inherited IRA remains in the family bloodlines and out of the hands of a beneficiary s spouse, or soon-to-be ex-spouse. Allows for experienced investment management and oversight of the IRA assets by a professional trustee. Prevents the beneficiary from dissipating the funds. Enables planning for a special needs beneficiary. Permits minor beneficiaries, such as grandchildren, to be beneficiaries a court supervised guardianship. Facilitates generation-skipping transfer tax planning. Downsides to tying up an IRA inside of a trust include compressed tax brackets which max out at $12,150 of income (in 2014), ongoing accounting and trustee fees, and the sheer complexity of administering the trust year after year. Trust Planning. To provide all of the benefits listed above and avoid mandatory liquidation of the inherited IRA within five years, a separate trust must be a see through trust. A see through trust insures that the required minimum distributions can either remain inside the trust (an accumulation trust ), or be paid out over the oldest trust beneficiary s life expectancy (a conduit trust ). Spouse Trust Planning. Provisions can be made in a standalone retirement trust for the benefit of a spouse. This may be important for many reasons aside from creditor protection, including a second marriage, when coupled with disclaimer planning, for a spouse who eventually needs nursing home care and seeks to qualify for Medicaid. A layered IRA beneficiary designation which includes a standalone retirement trust and disclaimer planning can offer flexibility for clients who want to insure that their retirement funds stay in their family s hands and out of the hands of creditors. 4

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