We know that section 522(b)(3)(C) of the bankruptcy code provides protection for “retirement funds.” However, up until now, we did not know whether an Inherited IRA was such an account. The U.S. Courts of Appeals had split decisions on this issue.
Certainly, when an IRA was started by the original participant, the IRA account was “retirement funds” and protected up to $1 million under the latest overhaul of the bankruptcy laws. However, the U.S. Supreme Court recently ruled in Clark v. Rameker that, once the participant dies, it loses its bankruptcy protection in the hands of the beneficiary.
Clark involved a $300,000 inherited IRA. The account was started by Ruth Heffron, as the participant in 2000. She named her daughter, Heidi Heffron-Clark, as the beneficiary and died the following year. So, in Heidi’s hands, the IRA (which initially had $450,000) was an Inherited IRA. In bankruptcy, Heidi asserted the Inherited IRA consisted of “retirement funds” protected under 522(b)(3)(C) of the bankruptcy code. The bankruptcy court held that Inherited IRAs do not receive protection in bankruptcy. The district court reversed. The 7th Circuit agreed with the bankruptcy court and reversed the district court. The U.S. Supreme Court agreed with the 7th Circuit and affirmed its decision.
The Court had three main reasons:
- Heidi could not contribute to the Inherited IRA.
- Heidi was required to take withdrawals from the Inherited IRA, even if many years prior to retirement.
- Heidi could withdraw the entire balance at any time with no penalty.
Even though the account started as a retirement account, the Court did not find this persuasive regarding its status once Ruth died and Heidi, as beneficiary, received it as an Inherited IRA.
What this case leaves unanswered is what bankruptcy protection, if any, would be afforded to an IRA which named the surviving spouse as beneficiary. While it is an Inherited IRA, it would get no bankruptcy protection. However, once it is rolled over, would it get protection?
Presumably it would get such protection. But, could doing a spousal rollover be considered a fraudulent transfer under some circumstances? These are open questions in light of Clark.
This case is an important one to keep in mind as you are helping your clients plan their estates, especially if the client is interested in asset protection for their beneficiary. The IRA which the client leaves will not be asset protected if a non-spousal beneficiary is named directly. If a trust for the non-spousal beneficiary is named as beneficiary of the IRA, then the asset protection of the trust envelope can protect the IRA for the beneficiary. With a spousal beneficiary, the solution is less clear. Certainly, naming the spouse directly allows the spouse to get maximum income tax deferral through a spousal rollover.
However, this will expose the IRA to the spouse’s creditors, at least until a spousal rollover is completed.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc..
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555