Ruth Heffron established a traditional IRA in 2000, and then promptly died the following year. At the time of Ruth's passing, there was $450,000 in the IRA
The sole beneficiary-on-death of Ruth's IRA was her daughter, Heidi Heffon-Clark. After Ruth passed, Heidi decided to take monthly distributions from the IRA.
Heidi received distributions for 9 years, which brings us to the year 2010 when Heidi and her husband filed for Chapter 7 bankruptcy. In their schedules, the couple listed Heidi's inherited IRA as being an exempt asset.
The Bankruptcy Trustee ("BKT") and the couples' creditors disagreed, and claimed that the funds from the inherited IRA were merely Heidi's inheritance -- and thus became an asset of the Bankruptcy Estate that was subject to distribution to creditors -- and were nothing like exempt "retirement funds" within the meaning of federal bankruptcy law, more particularly 11 USC § 522(b)(3)(C), which provides:
11 U.S. Code § 522 - Exemptions
(b)
(3) Property listed in this paragraph is—
(C) 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 1986.
Section 522 allows debtors such as Heidi and her husband to elect their state's exemption as opposed to the federal exemption, and they had done so in this case.
The BKT and creditors won in the Bankruptcy Court. The District Court, which reviews decisions of the Bankruptcy Court in the Seventh Circuit, disagreed and found in favor of Heidi and her husband. The Seventh Circuit agreed with the BKT and the creditors, and reversed the District Court.
The Seventh Circuit's ruling created a conflict with an opposite ruling by the Fifth Circuit (which would have found the inherited IRA to be exempt). Thus, the U.S. Supreme Court stepped in to resolve the conflict between the Circuits, and that's how this case over a $300,000 inherited IRA found itself before the SCOTUS (the now-popular acronym for Supreme Court of the United States).
Writing for a unanimous Court, Justice Sotomayor, first described an inherited IRA:
An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. [...] 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). [...] When anyone other than the owner’s spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account.
Inherited IRAs do not operate like ordinary IRAs. Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. [...] Indeed, the owner of an inherited IRA not only may but must withdraw its funds: The owner must either withdraw the entire balance in the account within five years of the original owner’s death or take minimum distributions on an annual basis. [...] And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account. [...]
Quotations omitted.
Justice Soyomayor noted that the phrase "retirement funds" is not defined in the Bankruptcy Code, and thus its ordinary meaning as "sums of money set aside for the day an individual stops working." To reach this determination, an objective test is used -- it doesn't matter what the debtor really intended to do with the money, but instead turns on whether the account is one that is set aside for retirement.
Applying this analysis, an inherited IRA is not money that is set aside for retirement. Justice Sotomayor focused on three things:
(1) The holder of an inherited IRA is prohibited from contributing additional moneys to the account;
(2) The holder of an inherited IRA is required to take mandatory withdrawals from the account whether the holder has retired or not; and
(3) The holder of an inherited IRA can withdraw the money at any time without penalty, and thus is not encouraged to save the money for retirement.
The result, the Court held, is consistent with general creditor-debtor law, whereby specific exemptions serve specific purposes, and here the purpose of exempting a traditional, non-inherited IRA is to provide for the retirement needs of debtors even to the detriment of their creditors. By contrast, an inherited IRA has no such purpose.
Justice Sotomayor rejected the arguments of Heidi and her husband that the funds were just retirement funds that they had set aside early, which of course was belied by her ability to take current distributions from the IRA.
ANALYSIS
Despite the Fifth Circuit's contrary ruling, the result of this Supreme Court appeal was widely predicted by bankruptcy and creditor-debtor lawyers, and was not much of a surprise if at all. Justice Sotomayor's reasoning can hardly be argued with, and indeed gained a unanimous opinion from a Court that has recently been characterized in other cases as being fractured.
For planners, however, the work-around is pretty simple: Folks with IRAs who want the balance of the moneys to be protected from their heirs' creditors should designate a spendthrift trust as the beneficiary of the balance, and not their heirs directly.
Indeed, this decision will probably cause a mini-boom in estate planning, and cause folks with anything like significant amounts in their IRAs to create trusts for their heirs instead of on death leaving those heirs the IRA accounts outright.
But that should be true for any significant asset, not just inherited IRAs. Probably one of the dumbest things one can do is to leave significant assets to their heirs outright, instead of leaving it to their heirs in a spendthrift trust.
Even when debtors don't have any current assets, it is a common practice for creditors to keep their judgments alive, set alerts in
Planning to leave assets in spendthrift trusts for children, to keep the assets out of the hands of the childrens' creditors, has a long and established history in Anglo-American law -- Thomas Jefferson created just such a trust for the benefit of one of his daughters, Martha, who married a husband who had financial difficulties. There is nothing slick or sleazy about it, but rather it is just good planning completely sanctioned by the spendthrift laws of each state.
Finally, there will be some advisers who might mumble something about, "My state's laws protect inherited IRAs, so I don't have to worry about this." Wrong.
Note that the applicable state exemption is where the debtor is located, not where the deceased is located, i.e., exemptions in these cases are exemptions of the debtor, not the person who left them the assets. The truth is that "kids move around", and over a period of years (nearly a decade in this case), trying to guess the state in which the debtor will be resident when the exemption is tested might be a low-odds proposition. If Mom and Daughter are both resident in a state where inherited IRAs are exempt under state law, and then Daughter moves to a state where inherited IRAs are not protected and Mom passes, then too bad so sad for Daughter, and too glad very happy for Daughter's creditors.
Which is an old song in asset protection planning -- trying to predict over a long period of years which state's laws will apply in the creditor-debtor context has always been dangerous.
So you had better protect for all of them.
CITE AS
Clark v. Rameker, ___ U.S. ____ (June 12, 2014).
This article at http://onforb.es/1xRy4PQ and http://goo.gl/YJpBXz
