Inherited IRA Not Protected in Bankruptcy

June 18, 2014

The Supreme Court recently decided a bankruptcy issue that has caused confusion in the lower courts. The issue is whether an inherited IRA receives the same protection in bankruptcy as other retirement assets. Ordinarily, an IRA is classified as a “qualified” retirement fund and receives protection from creditors and the bankruptcy trustee. In the case of Clark v. Rameker, the debtor, Clark, filed for Chapter 7 bankruptcy protection and listed a $300,000 IRA that he had inherited from his mother. Previously, the Seventh Circuit Court of Appeals disagreed with the Fifth Circuit and other lower courts over whether the debtor is entitled to qualified retirement fund protection when the asset is inherited.

In a 9-0 opinion, the Supreme Court held that funds in an individual retirement account inherited from someone other than the bankrupt debtor’s spouse are not “retirement funds” within the meaning of Section 522(b)(3)(C) of the United States Bankruptcy Code, and are available to pay creditors of the debtor-heir. The Court opined:

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.

This ruling is unfortunate for bankruptcy debtors seeking a fresh start, but the result can still be avoided with proper estate and bankruptcy planning. For instance, the Bankruptcy Code provides that a trust that expressly is limited by an enforceable transfer restriction (called a spendthrift provision) is not property of the debtor’s bankruptcy estate. See 11 U.S.C. § 541(c)(2). The typical spendthrift trust gives an independent trustee full authority to make decisions as to how the trust funds may be spent for the benefit of the beneficiary. This prevents the beneficiary from wastefully spending the trust assets, and also puts the trust corpus beyond the reach of creditors. Since the funds in the trust are not actually under the control of the beneficiary, the trust is also protected during bankruptcy.

If you are considering filing for bankruptcy please contact the experienced attorneys at Fears Nachawati for a free consultation. Call us at 1-866-705-7584 or send an email to fears@fnlawfirm.com.

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