IRAs in Bankruptcy
federal law (and under the laws of most
states), retirement plans such as IRAs
enjoy some protection in bankruptcy proceedings.
Does that same protection apply to inherited
IRAs? The issue has been disputed in many
court cases in recent years with mixed
verdicts. Finally, in June 2014, the U.S.
Supreme Court unanimously decided that
bankruptcy creditors may have access to
these accounts (Clark v. Rameker, No.
13-299 (U.S. 6/12/14)).
This ruling has implications for IRA owners
as well as for the beneficiaries of such
this case, Ruth Heffron held over $450,000
in her IRA. If Ruth had declared bankruptcy,
she probably could have kept certain IRA
assets. "Allowing debtors to protect
funds in traditional and Roth IRAs ensures
that debtors will be able to meet their
basic needs during their retirement years,"
the Supreme Court noted. Keeping
some assets from bankruptcy creditors
helps debtors "obtain a fresh start,"
reducing the chance that these debtors
will be "left destitute and a public
Many IRAs still hold assets when the owner
dies. Then, the IRA may pass to the designated
after Ruth died, her daughter Heidi Heffron-Clark
inherited the account. Nine years later,
Heidi and her husband filed for bankruptcy.
The couple asserted that the funds in
Heidi's inherited IRA, which now amounted
to almost $300,000, should be exempt from
such cases, debtors have prevailed some
of the time. Retirement funds held in
tax-exempt retirement accounts are protected
in bankruptcy, some courts have ruled,
and the funds in an Individual Retirement
Account remain retirement funds even after
they pass to a beneficiary and are held
in an inherited IRA.
courts, including the one ruling on Heidi's
case, found that funds in an inherited
IRA are no longer retirement funds because
the funds are not specifically set aside
for use by the beneficiary in retirement.
Thus, they are not protected in bankruptcy.
Heidi and her husband appealed to the
Supreme Court, which upheld the ruling
favoring the creditors in this case, the
Supreme Court gave several reasons why
funds held in an inherited IRA are not
funds set aside for retirement purposes.
First, a beneficiary can't contribute
to an inherited IRA. An individual can
put money into a Roth or traditional IRA
via annual contributions or direct transfers
or rollovers from other retirement accounts.
Indeed, various tax incentives encourage
As its second reason, the Court noted
that beneficiaries are required to take
minimum distributions from inherited IRAs,
even if they are many years from retirement.
Traditional IRA owners face required distributions
only after age 70V2, when they are likely
to be retired, and Roth IRA owners never
have to withdraw funds. Finally, the Court
noted that "the holder of an inherited
IRA may withdraw the entire balance of
the account at any time- and use it for
any purpose-without penalty." Traditional
and Roth IRA owners, on the other hand,
generally are subject to penalties for
early withdrawals before age 59 1/2.
After this decision, people who declare
bankruptcy can't expect to protect inherited
IRAs from creditors. Therefore, IRA owners
should review their choice of IRA beneficiaries.
If a future bankruptcy filing by a beneficiary
is a concern, you might designate an irrevocable
trust as the beneficiary of your IRA and
name your human heir as the trust beneficiary.
Such a procedure may increase the chance
that the IRA will enjoy protection in
surviving spouses who inherit an IRA from
the other spouse might be affected by
this decision. A spousal beneficiary "may
roll over the IRA funds into his or her
own IRA, or he or she may keep the IRA
as an inherited IRA," the Supreme
Court observed. Once the IRA has been
rolled over into the surviving spouse's
own IRA, it probably will be protected
some spousal beneficiaries choose to keep
the account as an inherited IRA. That's
often the case if the survivor intends
to take withdrawals before age 59/4 and
wants to avoid a 10% early withdrawal
penalty. The Supreme Court's decision
does not indicate whether an inherited
IRA held by a surviving spouse would get
bankruptcy protection, but all of the
reasons cited to disallow such protections-no
future contributions, required minimum
distributions at any age, no penalties
for early distributions-apply to inherited
IRAs held by a surviving spouse. Therefore,
any widow or widower who is considering
leaving a deceased spouse's IRA as an
inherited IRA might discuss creditor protection
issues with a knowledgeable attorney.
you should keep in mind that the Supreme
Court's decision applies to bankruptcy
cases, not other types of creditors' claims.
In non-bankruptcy litigation, state law
usually will determine whether inherited
IRAs are protected from creditors. Some
states specifically protect inherited
IRAs, but most states have not passed
relevant legislation. Again, you should
consult with counsel if this is a concern.
Source: September 2014 AICPA Client