Ruth Heffron established a traditional IRA in 2000, naming her daughter, Heidi Heffron-Clark, as the sole beneficiary of the account. After Heffron died in 2001, her IRA account, then containing approximately $450,000.00, passed to Clark as an inherited IRA. In October 2010, Clark and her husband filed a chapter 7 bankruptcy petition, listing the inherited IRA, at that time worth approximately $300,000.00, as exempt under section 522(b)(3)(C) of the Bankruptcy Code. Rameker, the chapter 7 trustee, and several unsecured creditors objected to the claimed exemption, arguing that funds contained in an inherited IRA do not constitute “retirement funds” within the meaning of the statute.
The Bankruptcy Court agreed with Rameker and disallowed Clark’s claimed exemption, relying on the plain language of section 522(b)(3)(C), finding that an inherited IRA does not contain anyone’s
“retirement funds.” The District Court reversed, finding that section 522(b)(3)(C) covers any account containing funds that were originally accumulated for retirement purposes. On appeal, the Seventh Circuit reversed the District Court, emphasizing the different rules governing inherited IRAs as compared to traditional IRAs. The Seventh Circuit found that “inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.”
Justice Sotomayor began her opinion by examining the language used in section 522(b)(3)(C). She determined that the term “retirement funds,” as used in section 522(b)(3)(C), is “properly understood to mean sums of money set aside for the day an individual stops working.” Turning to the legal characteristics of traditional and inherited IRAs, the Court identified three primary differences justifying its holding.
“First, the holder of an inherited IRA may never invent additional money in the account.” To the Court, this aspect of inherited IRAs made those accounts vastly different than traditional IRAs, “[f]or where inherited IRAs categorically prohibit contributions, 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."
“Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement.” The Court noted the Tax Code requires inherited IRA beneficiaries to either draw down the entire account within five years after the owner’s death or take minimum annual distributions each year. In contrast to traditional IRAs, where the Tax Code promotes saving these funds for a later date, the Tax Code requires the beneficiary to withdraw the funds in an inherited IRA, regardless of the beneficiary’s age or working status.
“Finally, 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 emphasized how starkly different this is from traditional IRAs, where owners pay 10% tax penalties for withdrawals made prior to age 59½. Based on these three primary differences, the Court had little trouble concluding that inherited IRAs do not contain funds that qualify as “retirement funds” for the purposes of section 522(b)(3)(C).
In sum, the Court’s decision is one that bankruptcy trustees and creditors will surely welcome, though at the expense of individual debtors. Debtors and consumer bankruptcy attorneys will now need to look closely at the exemptions available under their state laws to determine whether they can exempt the funds in inherited IRAs under some other legal theory, since they can no longer do so under the Bankruptcy Code.