Inherited IRAs Aren't Creditor-Safe, Court Says

     WASHINGTON (CN) - Resolving a circuit conflict, the Supreme Court said today that inherited IRAs are not protected from creditors' claims as "retirement funds."
     At issue is an individual retirement account (IRA) worth $300,000 that passed to Heidi Heffron-Clark after the death of her mother, Ruth Heffron.
     Unlike regular IRAs, inherited IRAs cannot be used as the beneficiary's retirement savings account, but must be distributed within five years. This ensures that the money held in an IRA, which is tax-free until its withdrawal, cannot be passed on through the generations without paying income tax.
     Heffron-Clark and her husband, Brandon, declared bankruptcy, however, during the five-year distribution period.
     Although IRA funds are generally protected from creditor's claims, the bankruptcy judge found that money in an inherited IRA is not exempt because it cannot be held for Heffron-Clark's own retirement.
     A federal judge in Madison, Wis., reversed that ruling, however, finding that retirement funds in a decedent's possession should be treated the same way in the successor's hands.
     The 5th Circuit agreed with this reasoning that same year in In re Chilton, but a three-judge panel of the 7th Circuit created a circuit split in April 2013 while reviewing the Heffron-Clarks' case.
     "By the time the Clarks filed for bankruptcy, the money in the inherited IRA did not represent anyone's retirement funds," the ruling against Heffron-Clark said (emphasis in original).
     After taking up the case in November, the Supreme Court unanimously affirmed Thursday based on several differences between inherited IRAs and typical retirement accounts.
     Whereas "inherited IRAs categorically prohibit contributions," for example, "the entire purpose of traditional and Roth IRAs is to provide tax incentives for accountholders to contribute regularly and over time to their retirement savings," Justice Sonia Sotomayor wrote for the court.
     Sotomayor also noted that there are designated timelines in place for the withdrawal of money from inherited IRA accounts, no matter how many years the holder may be from retirement.
     In this case the Clarks "elected to take yearly distributions from the inherited IRA; as a result, the account decreased in value from roughly$450,000 to less than $300,000 within 10 years," the 13-page ruling states.
     "That the tax rules governing inherited IRAs routinely lead to their diminution over time, regardless of their holders' proximity to retirement, is hardly a feature one would expect of an account set aside for retirement," Sotomayor wrote.
     It is possible moreover for holders of inherited IRAs to "withdraw the entire balance of the account at any time - and for any purpose - without penalty," according to the ruling.
     "Whereas a withdrawal from a traditional or Roth IRA prior to the age of 59½ triggers a 10 percent tax penalty subject to narrow exceptions - a rule that encourages individuals to leave such funds untouched until retirement age - there is no similar limit on the holder of an inherited IRA," Sotomayor wrote. "Funds held in inherited IRAs accordingly constitute 'a pot of money that can be freely used for current consumption,' not funds objectively set aside for one's retirement."     
     The justices also emphasized how the safeguards built into retirement accounts "ensure that debtors will be able to meet their basic needs during their retirement years," while also keeping debtors from seeing "a cash windfall by virtue of the exemption - such debtors are instead required to wait until age 59½ before they may withdraw the funds penalty-free."
     "The same cannot be said of an inherited IRA," Sotomayor wrote. "For if an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing about the inherited IRA's legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code's purposes of preserving debtors' ability to meet their basic needs and ensuring that they have a 'fresh start.'"
     The Clarks failed to persuade the justices that the funds in their inherited IRA remain retirement funds because that is the purpose for which they were set aside.
     "Under petitioners' contrary logic, if an individual withdraws money from a traditional IRA and gives it to a friend who then deposits it into a checking account, that money should be forever deemed 'retirement funds' because it was originally set aside for retirement," Sotomayor wrote. "That is plainly incorrect."