What happens to your Momma’s IRA when you file for Bankruptcy?

And the answer to that question is… we’re not sure. However, Clark v. Rameker, a case currently pending before the Supreme Court, will hopefully answer this question.

Facts of the Case

In 2001, Heidi Heffron-Clark inherited a $300,000 individual retirement account (“IRA”) from her mother’s estate. Sometime after 2001 but before 2010, Heffron-Clark took $7,000 out of the retirement account so that the remaining balance on the account was $293,000. Heffron-Clark then filed for Chapter 7 in 2010 after her pizza shop closed. The court appointed trustee in her case went after the retirement plan that Heffron-Clark had inherited from her mother arguing that it was part of the debtor’s estate. Heffron-Clark argued that the IRA was exempt under Section 522 of the Bankruptcy code. Section 522(b)(4)(A) reads:

(A) If the retirement funds are in a retirement fund that has received a favorable determination under section 7805 of the Internal Revenue Code of 1986, and that determination is in effect as of the date of the filing of the petition in a case under this title, those funds shall be presumed to be exempt from the estate.

At the trial court level, the bankruptcy judge ruled that retirement funds must be held for the debtor’s retirement in order to qualify as an exempt retirement fund under Section 522 of the U.S. Bankruptcy Code. He further stated that because the debtor withdrew $7,000 from the inherited fund before her retirement, the fund was not for the debtor’s retirement and was therefore subject to creditor claims in the bankruptcy proceeding. The federal district court reversed the Bankruptcy court’s decision. The district court held that the debtor’s inheritance of the IRA did not change its status as a protected retirement fund. Finally, the Seventh Circuit reversed and SCOTUS granted cert.

Issue

Does the U.S. Bankruptcy Code exempt an inherited IRA from a debtor’s estate in bankruptcy?

Analysis

In the upcoming years, there is likely to be an increase in the type problem that faced the debtor in this case. The incidence of IRA inheritance is likely to increase because of the aging baby-boomer population. Children of the baby-boomers will begin inheriting their parent’s IRAs in greater numbers. Therefore, it is now more important than ever for SCOTUS to clarify the ambiguity in the Bankruptcy Code in regard to whether an inherited IRA becomes part of the debtor’s estate in bankruptcy. 

From what many experts have to say on this topic, SCOTUS is likely to hold that inherited IRA’s are not exempted from the estate under Section 522. Once an IRA is passed down to someone other than a spouse, it ceases to behave like a retirement account and the beneficiary is permitted to spend the money for any purpose. The U.S. tax code provides special rules for IRAs that are inherited by someone other than the spouse of the deceased. These rules prohibit additional contributions to the inherited account and require the beneficiary to withdraw, and pay taxes on, a minimum amount from the account each year. According to one expert, “inherited IRAs are better characterized as anti-retirement funds because they are required to be spent almost immediately. The non-spouse beneficiary who inherits an IRA also can’t put more money into that account and faces deadlines to begin spending the inherited money.” Furthermore, during last week’s oral arguments Justice Elena Kagan remarked, that an inherited IRA “doesn’t seem like a retirement fund in people’s natural understanding of the language.”

Oral arguments in Clark v. Rameker were heard on March 24, 2014 so we will have to wait until June to see how SCOTUS decides this issue. I will do my best to keep you updated on any further developments.