Inherited IRAs do not qualify for bankruptcy exemption, Supreme Court rules

A debtor’s inherited IRA did not qualify for the bankruptcy exemption provided in Section 522(b)(3)(C) of the U.S. Bankruptcy Code because the funds in inherited IRAs were not “retirement funds” within the meaning of Section 522(b)(3)(C), the U.S. Supreme Court has held in an unanimous decision.

Note: The Supreme Court’s conclusion resolved a conflict among the circuits.

At the time of her death, a decedent owned an IRA worth a little more than $450,000. Her daughter was the designated beneficiary and elected to take monthly distributions from the account. Subsequently, a bankruptcy proceeding was initiated by the daughter and her husband. They identified the inherited IRA, which was then worth about $300,000, as exempt from the bankruptcy estate under Section 522(b)(3)(C) of the U.S. Bankruptcy Code. The bankruptcy trustee and unsecured creditors of the estate objected to the claimed exemption, arguing that the funds in the inherited IRA were not “retirement funds” within the meaning of the statute.

Section 522(b)(3)(C) of the Bankruptcy Code exempts from creditors’ claims any “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code.” The bankruptcy court agreed with the bankruptcy trustee and the creditors, and disallowed the exemption. The federal district court reversed, holding that any money representing “retirement funds” in the hands of the decedent must be treated the same way in the hands of the beneficiary. This view is in accord with the holding of the Fifth Circuit in In the Matter of Chilton.

The Seventh Circuit reversed the district court’s judgment, pointing to the different rules for inherited and noninherited IRAs. The court concluded that “inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.”

Inherited IRA funds are not retirement funds

The Supreme Court affirmed the Seventh Circuit decision, holding that “[t]he text and purpose of the Bankruptcy Code make clear that funds held in inherited IRAs are not “retirement funds” within the meaning of §522(b)(3)(C)’s bankruptcy exemption.”

Since the Bankruptcy Court does not define “retirement funds,” the Court gave the term its ordinary meaning. The Court determined that Section 522(b)(3)(C)’s reference to “retirement funds” meant sums of money set aside for the day an individual stops working. Three legal characteristics of inherited IRAs provided objective evidence that funds held in such accounts were not set aside for the purpose of retirement, according to the Court. First, the holder of an inherited IRA is not allowed to contribute additional money to the account. “Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement. Third, the holder of an inherited IRA may withdraw the entire balance of the account at any time—and for any purpose—without penalty.”

The Court stated that its reading of the text was consistent with the purpose of the Bankruptcy Code’s exemption provisions, which produce a careful balance between the interests of creditors seeking to recover assets and of debtors attempting to protect essential needs. Allowing debtors to protect funds held in traditional and Roth IRAs helps debtors meet their basic needs during their retirement years. However, they are limited by the requirement that they must wait until age 59½ to withdraw funds penalty free. But nothing about the inherited IRA’s legal characteristics would prevent or discourage an individual from using the entire balance of the account immediately after bankruptcy, the Court explained. The owner of an inherited IRA may withdraw funds at any time without incurring a penalty and must withdraw funds by taking either the entire balance within five years of the original owner’s death or minimum distributions annually. The “retirement funds” exemption should not be read in a manner that would convert the bankruptcy objective of protecting debtors’ basic needs into a “free pass,” according to the Court.

The debtors’ arguments did not overcome the statute’s text and purpose, according to the Court. Their claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for retirement, conflicted with ordinary usage and rendered the term “retirement funds,” as used in Section 522(b)(3)(C), superfluous. Section 522(b)(3)(C) requires that funds satisfy two conditions in order to be exempt—the funds must be “retirement funds,” and they must be held in a covered account. The debtors’ interpretation would write out of the statute the first element. The debtors argued that many of Section 522’s other exemptions refer to the “debtor’s interest” in various kinds of property, but not Section 522(b)(3)(C). The absence of the phrase “debtor’s interest” did not indicate that Section 522(b)(3)(C) covered funds were intended for someone else’s retirement, according to the Court. Where used, that phrase limits the value of the assets that a debtor may exempt from his or her estate. It does not distinguish between a debtor’s assets and the assets of another. The Court also found unpersuasive the debtors’ assertion that Section 522(b)(3)(C)’s sentence structure— i.e., a broad category, “retirement funds,” followed by limiting language, “to the extent that”—prevented the broad category from performing any independent limiting work. The Court noted that this was not the only way in which the phrase “to the extent that” could be read, and this argument reintroduced the problem of making the term “retirement funds” superfluous. Finally, the possibility that some account holders might leave an inherited IRA intact until retirement and take only the required minimum distributions did not mean that an inherited IRA bore the legal characteristics of retirement funds.
Source: Clark v. Rameker (US Sup Ct).
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