The recent Supreme Court ruling in Clark v. Rameker will have a lasting impact on one of the most prominent ways of saving for retirement. In its June 12, 2014 opinion, the Court settled a split between the 5th and 7th Circuits when it ruled that inherited IRAs are not protected from creditors in federal bankruptcy proceedings.
The confusion over this issue stemmed from the fact that the U.S. Bankruptcy Code protects many tax-exempt retirement funds, including both traditional and Roth IRAs, but makes no mention of whether this exemption applies to inherited IRAs. This uncertainty lead to a split in the U.S. Circuit Courts on the issue, with the 5th Circuit holding that inherited IRAs were exempt from bankruptcy proceedings and the 7th Circuit holding they were not, and resulted in confusion among IRA owners.
In its June 12 decision, the Court provided clarity on this issue. The Court distinguished inherited IRAs from other forms of IRAs held by the original owner based on three legal characteristics: (1) inherited IRA owners are not allowed to make further contributions to the account; (2) inherited IRA owners must withdraw funds from the inherited IRA; and (3) inherited IRA owners are not subject to any age-related penalties for withdraws from the account. Pointing to these three characteristics, the Court ruled that inherited IRAs do not constitute retirement accounts for purposes of the Bankruptcy Code, and therefore are not exempt from bankruptcy proceedings.
This ruling has significant implications for IRA holders concerning how they plan for both their own future and the future of their potential beneficiaries. While this ruling will not impact a spouse that inherits an IRA and otherwise characterizes the inherited IRA as his/her own, it will impact other recipients inheriting IRAs. For example, if the IRA passes to a non-spouse beneficiary, or the surviving spouse chooses not to roll the deceased spouse’s IRA into his or her own IRA, in light of this ruling, the inherited IRA will not be considered a retirement account and will be subject to claims in any future bankruptcy proceedings. Due to this, IRA owners should carefully consider who they name as the beneficiary of their IRA, as the account will not receive the protections many have come to expect. Furthermore, this ruling may encourage IRA owners wishing to provide future protection for their nonspouse beneficiaries to create a spendthrift trust as the beneficiary of their IRA, which trust may itself provide some protection in a bankruptcy proceeding.