Home News The ‘R’ in inherited IRA Does Not Stand for Retirement

By Pamela Ritter

The implications of the US Supreme Court’s Clark v. Rameker decision

On June 12, 2014, US Supreme Court Justice Sonia Sotomayor, on behalf of a unanimous Court confirmed inherited IRAs are not “retirement funds.” This means an inherited IRA is not tax exempt (11 U.S.C. 522 (b)(3)(C)). This decision notably alters the landscape of inherited IRA’s under the Bankruptcy Code.

A look at the past: inherited IRAs before Clark

Pamela Ritter
Pamela Ritter

Before the Clark decision, spouses, children, close friends and relatives were often named as beneficiaries of inherited IRAs with the expectation that these funds would be protected from the claims of creditors. Individuals as well as creditors presumed assets held in an inherited IRA were exempt from creditors under the Bankruptcy Code because they were considered “retirement funds”. Eight courts supported this position, reasoning that funds contained in inherited IRAs remained “retirement funds.” The Bankruptcy Court for the Western District of Wisconsin broke from the majority view and held that a debtor’s inherited IRA was not exempt under the Bankruptcy Code. This set the stage for the path Clark would take to the United States Supreme Court.

A look at the present: the Clark opinion

The Court’s 2014 decision was the culmination of a case that began in 2000 with Ruth Heffron, who named her daughter Heide Heffron-Clark, the sole beneficiary of her traditional IRA. When Ruth Heffron’s husband died, she rolled his IRA over into her account. When Heffron died in 2001, her IRA passed on to her daughter as an­ inherited IRA. Heidi Heffron-Clark began taking monthly distributions in 2002. Shortly after, she and her husband opened a pizza parlor in Stoughton, Wisconsin. Unfortunately, the pizzeria failed in the face of the recession. Seeking financial relief, the couple filed a Chapter 7 bankruptcy petition in the Western District of Wisconsin. In their bankruptcy petition, the Clarks listed the inherited IRA with a value of approximately $300,000, as exempt. Arguing that the inherited IRA is not a “retirement fund” according to the exemption statute, the Chapter 7 trustee and the other creditors objected to the exemption. The bankruptcy court agreed with the trustee, beginning the case’s contentious journey through the district court, which reversed the ruling, the Seventh Circuit, which upheld the ruling, and ultimately the Supreme Court which agreed with the bankruptcy court’s initial decision.

The Supreme Court concluded that the funds in the inherited IRA hold three legal characteristics  that keep them from being considered ‘objectively put aside for the purpose of retirement.’

The three key points are:

  1. The holder of an inherited IRA may not invest additional sums into the account.
  2. The holder of an inherited IRA is required to begin withdrawing money a short time after inheriting the funds, no matter how many years he or she may be from retirement.
  3. The holder of an inherited IRA can withdraw the entire balance of the account at any time without penalty.

The Court emphasized that allowing an exemption for inherited IRAs could encourage debtors to delay withdrawals until after their bankruptcy is closed and then use the funds for non­retirement purposes. Thus, the Court concluded that an inherited IRA is not exempt.

A look at the future: bankruptcy, inherited IRAs, and estate planning in a post-Clark environment

How will Clark impact the bankruptcy process and estate planning moving forward? In the bankruptcy context, inherited IRAs are no longer exempt under the federal exemptions.
In the estate planning context, in general a non-spousal IRA heir must withdraw the full account within five years of the initial owner’s death or take out minimum amounts each year starting before December 31 of the year after the IRA owner dies the “Stretch IRA”. This leads to tax deferral strategies for beneficiaries that want a longer than 5-year payout period.

One way to protect a non-spousal IRA inheritor is to leave the funds in a trust. There are multiple strategies to use around trusts.
Same-sex couples will also have special planning concerns. Unless they are married, the only way to leave a retirement account to a partner and avoid immediate income taxation is through an inherited IRA.

Closing points

As in the past, the traditional IRA holder can state the spouse as the primary beneficiary and any adult children as secondary beneficiaries The Clark ruling applies to non-spousal IRA cases. Advisors and their clients should discuss whether there are specific issues or circumstances such as creditor issues or special needs. Some circumstances may warrant a different beneficiary designation.

Pam Ritter has over 20 years of experience with providing legal counsel and advice to community, regional and national financial institutions. She specializes in banking law, creditors’ rights and commercial real estate.