U.S. Supreme Court Says Inherited IRA's Not Exempt in Bankruptcy

June 19, 2014 | Roger McEowen

Clark v. Rameker, No. 13-299, 2014 U.S. LEXIS 4166 (U.S. Sup. Ct. Jun. 12, 2014).


On June 12, the U.S. Supreme Court ruled that a bankruptcy debtor’s inherited IRA does not constitute “retirement funds” and, as such, is not exempt from creditors.  The Court’s opinion has planning implications for clients, but the Court’s holding may not have application to debtors in all states.  

Facts of the Case

The debtor's mother established a traditional IRA and named her daughter (the debtor) as the sole beneficiary.  About a year later, the mother died and the IRA account containing approximately $450,000 passed to the daughter as an inherited IRA which the daughter rolled into her own IRA. The daughter elected to take monthly distributions from the account before retiring. Approximately nine years later, the daughter (and her husband) filed Chapter 7 bankruptcy and claimed the IRA account (with a balance of approximately $300,000 at the time) as an exempt asset by virtue of 11 U.S.C. §522(b)(3)(C).  

Bankruptcy court.  The bankruptcy court (450 B.R. 858 (Bankr. W.D. Wis. 2011)) ruled that the IRA account was not exempt on the basis that inherited IRA funds are not "retirement funds" in the hands of the debtor and, therefore, are not exempt. 

District court.  On review, the district court (466 B.R. 135 (W.D. Wis. 2012)) determined that IRA account funds need not be “retirement” funds of the debtor to qualify for the exemption.  The district court followed the majority view that direct transfers of retirement funds from a tax-exempt account qualify for the exemption, and that it was immaterial that there are differences between traditional IRAs and inherited IRAs due to I.R.C. §408(e)(1).  The court noted that the question of whether an inherited IRA should be exempt was up to the Congress to change the statute. 

Seventh Circuit.  On further review (In re Clark, 714 F.3d 559 (7th Cir. 2013)), the circuit court reversed on the basis that inherited IRAs represent an opportunity for current consumption in the hands of the debtor and are not a fund of retirement savings.  The court analogized the situation to that of the debtor inheriting a home - the home is only exempt if the debtor lived in it, and is not exempt merely based on how the prior owner used the property. The appellate court's opinion is contrary to Fifth Circuit in In re Chilton, 674 F.3d 486 (5th Cir. 2012).

U.S. Supreme Court’s Opinion

The U.S. Supreme Court granted certiorari to clear-up the split among the circuit courts on the issue, and affirmed the Seventh Circuit. The court reasoned that inherited IRAs are not "retirement funds" within the meaning of 11 U.S.C. §522(b)(3)(C), because the holder of the inherited IRA may never invest additional funds, the holder must withdraw funds irrespective of how many years remain until retirement, and the holder can withdraw the entire account balance on demand at any time without penalty.

Implications of the Supreme Court’s Opinion

It is important to note that the Court’s decision does not impact all inherited IRAs.  The Court’s opinion only addressed the federal exemption for inherited IRAs.  However, states can, via legislation, prohibit the use of federal exemptions, and 33 states have taken such action. 

Note:  The following states and territories have not opted out of the federal exemptions, and the Supreme Court’s opinion would be applicable to bankrupt debtors in these states: AK, AR, CT, DC, HI, KY, MA, MI, MN, NH, NJ, NM, PA, PR, RI, TX, VT, VI, WA and WI.

Debtors in the “opt-out” states can only use exemptions provided under non-bankruptcy law.  In general, that means that such debtors are limited to state law exemptions.  Clearly, debtors in these states that have a specific exemption for inherited IRAs would not be impacted by the Court’s decision.  Presently, the states with such statutory language are Florida, Missouri, North Carolina and Texas.  However, in the “opt-out” states that do not have a specific exemption for inherited IRAs (such as Iowa) the courts could look to the logic in the Supreme Court case for guidance.  If the trial courts look to the Supreme Court for guidance, the debtor will lose.

A practical problem is that the state law of the beneficiary’s domicile at the time the beneficiary files bankruptcy controls, assuming that the beneficiary has resided in that state for at least two  years before bankruptcy filing.  If not, according to 11 U.S.C. §522(b)(3)(A), the bankruptcy exemptions will be governed by the law of the state where the beneficiary resided for the greater part of the 180 days preceding the 730-day period before filing for bankruptcy. That can be an unknown variable, and may mean that trust planning to avoid the impact of the Court’s decision is important.  Also, if the beneficiary’s state opts-out of the federal exemptionsdoesn’t have clear statutory language exempting inherited IRAs, but provides for creditor protection for annuities, it may be beneficial to convert the IRA into an IRA annuity to achieve creditor protection.