United States

US Supreme Court ruling necessitates asset protection planning for IRAs


The U.S. Supreme Court recently ruled in Clark v. Rameker (13-299) that inherited IRAs are not protected in bankruptcy. In a cursory, 11-page opinion, the Court said that the text and purpose of the bankruptcy code “make clear that funds held in inherited IRAs are not ‘retirement funds’ within the meaning of section 522(b)(3)(C)’s bankruptcy exemption.” Inherited IRAs are not retirement funds due to three attributes created by the Treasury Regulations governing the accounts. The Court first noted that holders of inherited IRAs are prohibited from contributing their own funds to the inherited IRA accounts. As such, inherited IRAs are not like traditional or regular IRAs that encourage contributions by offering tax benefits for such contributions. The opinion then discusses the obligation of the IRA beneficiary to withdraw the minimum required distribution each year, beginning the year following the date of the original account owner’s death. Again, the Court states that the required withdrawal differentiates the inherited IRA from the traditional IRA, where the owner can postpone withdrawals to age 70 ½ in the case of a traditional IRA and to the end of his or her lifetime in the case of a Roth IRA. The final attribute is the right–regardless of whether a stretch payout is elected−to withdraw all the funds at any time without penalty.

The third attribute was the one that swayed Justice Ginsburg, as she stated during oral argument in the case on March 24. The Court’s conclusion regarding the second rationale–the effect of the required minimum distributions–is empirically unsound. As shown in the two charts that appear in Are inherited IRAs exempt in bankruptcy, beneficiaries who invest wisely and withdraw only the minimum amount required by law will be rewarded with the considerable financial benefit of long-term tax deferral. The account will continue to appreciate in value for a long time–possibly in excess of 20 or 30 years–before the withdrawals will begin to outpace the appreciation. Justice Sotomayor did consider this argument at the very end of her opinion, but said that “the possibility that some investors may use their inherited IRAs for retirement purposes does not mean that inherited IRAs bear the defining legal characteristics of retirement funds.” Of course, the Court overlooked the fact that the “defining legal characteristic” of a retirement account is tax exemption, and it is the tax exemption and deferral that give the inherited account the attribute of a retirement fund.


Heidi Heffron-Clark inherited an IRA from her mother when her mother died in 2001. On Oct. 28, 2010, Heidi and her husband filed for bankruptcy and claimed that the inherited IRA was exempt under federal law. The Clarks’ small business had faltered during the Great Recession. The bankruptcy court judge ruled against them. The district court reviewed that decision and ultimately sided with the judges from the Fifth Circuit Court of Appeals decision in In re Chilton, 674 F.3d 486 (5th Cir., 2012) and the Eighth Circuit Bankruptcy Appellate Court decision in In re Nessa, 426 B.R. 312 (8th Cir., 2010). These courts ruled that an inherited IRA was a retirement account administered under sections 401 and 408. These appellate opinions explained that the only relevant inquiry was the purpose for which the funds were originally set aside and noted that the retirement account remained a retirement fund, regardless of who acceded to ownership of the account. Their analysis is best described as the “single account theory.”

The bankruptcy trustee then appealed the district court decision to the Seventh Circuit Court of Appeals. The Seventh Circuit ruled that once the original account owner dies, the IRA is no longer a retirement fund (Clark v. Rameker, 714 F.3d 559 (7th Cir. 2013)). The only characteristic of the account that is relevant, said the Seventh Circuit panel, is whether distributions from the account can be postponed until the beneficiary’s own retirement. In this way, bankruptcy protection extends only to the account of the person who participated in the retirement plan or his or her spouse. An inherited IRA is not a retirement fund because the new owner must begin withdrawing the account in the year following the year of the account owner’s death, the court concluded.

The case comes at a pivotal point in the evolution of retirement planning. Retirement savings are under fire. The Obama Administration has advocated in Congress for proposals that would terminate the stretch payout option and cap the value of an IRA at roughly $3.5 million. Termination of the stretch payout option has been proposed on the Senate floor as recently as 2013. Based on the oral argument in the case, several of the Supreme Court Justices, as well as the Seventh Circuit panel that ruled in the Clark case, clearly believe that inherited IRAs are too good of a deal. This opinion will bolster that side of the debate, but the debate is far from over. The countervailing argument, which was made by the petitioner in Clark and strenuously made by the Tribune Company in an amicus brief written on behalf of its employees, provides that Congress has spent 40 years incentivizing retirement savings in 401(k)s and IRAs and should not change the rules at this juncture. These incentives stem from both the Internal Revenue Code and the Bankruptcy Code. The Tribune brief urged that all inherited IRAs, whether transferred to dependents or spouses, should be protected in bankruptcy.

The debate over the proper treatment of and appropriate incentives for retirement savings takes place at a time of an unprecedented transfer of retirement assets from the baby boomer generation to its children. According to studies cited in the Tribune Company brief, due to employee turnover, retirement funds in 401(k)s are increasingly rolled over into IRAs, which now account for 25 percent of all retirement assets in the United States. Almost 50 million Americans now hold approximately $5.7 trillion in IRAs. These numbers have doubled in this millennium.

Winners and losers
The big winners of this decision are the certified financial planners, accountants and trust attorneys who will advise the millions of IRA account owners as to how to protect the beneficiaries of their IRA accounts from creditors in the coming months and years. Under existing law, trust planning can circumvent the Clark decision. Section 408 provides that a trust can be a designated beneficiary of an IRA. Trusts that qualify as designated beneficiaries are nicknamed “see-through” or “look-through” trusts, as the IRS will look through the trust to the individual trust beneficiaries for administrative purposes. As such, these trusts qualify for the advantageous, stretch payouts that permit the account to continue to appreciate in value for decades in many cases. For many individuals and couples, IRA accounts are their largest single asset. Many taxpayers, if not most, are risk averse and would prefer to protect their assets in a trust rather than worry that a personal guarantee extended by an heir as part of a mortgage or business financing arrangement could ultimately jeopardize the use of assets they bequeathed to their heirs through an inherited IRA.

Trusts repel creditors due to spendthrift provisions. A spendthrift provision is a restraint on voluntary or involuntary alienation of a beneficiary’s interest in a trust. It is an unfortunate label, with its connotation of protecting beneficiaries who would blithely waste any inherited funds and missing the more accurate depiction as an anti-alienation device. The concept stems from a settlor’s right to govern the terms under which distributions are made from a trust he or she created. A typical provision provides that no beneficiary has the right to assign or alienate his interest in the trust and that no creditor has a right to lien or levy against any interest that may be distributable to such beneficiary.

Probate attorneys will also be helping clients avoid the result in Clark. To the extent that heirs have creditor problems at the time of the death of a parent, disclaimers can often be used to avoid distribution of retirement assets to a child with a creditor issue. Trust planning can help here as well to create a road map for protection if a disclaimer is made.

While the Clark opinion on its face benefits creditors (and that will likely be the case in the short term), over the long term, many IRA owners will use trusts to protect the beneficiaries of the accounts. Spousal rollovers remain a viable planning option as well, as long as the spouse names a trust as the ultimate recipient of his or her inherited account. Now that the lifetime exemption amount from estate tax for a married couple is $10.68 million, many IRA account owners can enjoy protection from bankruptcy as well as estate tax deferral under current law by using a spousal rollover.

States offer bankruptcy protection for inherited IRAs

Federal bankruptcy statutes do not preempt the states from creating their own bankruptcy exemptions. Rather, Congress left the determination of property rights in the bankruptcy context to state laws. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the 2005 statute that exempted retirement funds and made other bankruptcy code revisions, is complicated by the ability of states to opt in or opt out of the federal exemption scheme. Currently, seven states have enacted statutes exempting inherited IRAs in bankruptcy. These seven states are: Arizona, Alaska, North Carolina, Missouri, Florida, Texas and Ohio. Although receiving considerable ink in the Clark briefs and discussed at several points in the oral argument, neither this disparate treatment nor the resulting chaos was mentioned by the Court in its opinion. It is likely, nonetheless, the new frontier for the debate over inherited IRAs and bankruptcy exemption. No doubt state legislatures will be inundated with bills exempting inherited IRAs. States are very competitive in vying for retirement assets and, as discussed above, there are $5.7 trillion in IRA assets. States will want to offer the protection as a way to lure and retain retirees. The U.S. Supreme Court refused to recognize a connection between protecting inherited IRAs in bankruptcy and incentivizing retirement savings, but the connection has been shown in several studies cited in the Tribune brief. Congress and state legislatures have acted on numerous occasions (including BAPCPA) to eliminate disincentives to save for retirement. The U.S. Supreme Court clearly created a disincentive to use IRAs to save for retirement, but it is probable that a few more states will act to exempt inherited IRAs, especially those states with a significant number of retirees. In this way, the U.S. Supreme Court has pushed this issue back on to the states.

Final lessons from the Clark case

Under the surface of the arguments made by the respondent and the Seventh Circuit judges and in the Supreme Court opinion is a policy debate on whether there should be a “natural right” to pass assets to one’s heirs and whether inherited assets of any kind should be protected in a subsequent bankruptcy. But, this debate has already been resolved and misses the point. By utilizing trusts to hold retirement accounts, the assets are protected from creditors under state law. Once states passed laws permitting spendthrift provisions to be built into trusts and case law developed permitting a testator almost absolute freedom to decide the conditions that would govern the distributions of income and corpus from trusts, a framework was created for protecting all assets, not just retirement accounts. Furthermore, when the Treasury Department  created regulations that permit trusts to hold retirement accounts, the ability to make retirement accounts available to subsequent generations, regardless of their creditor issues, was cemented. Thus, the policy dispute is less about achieving a debtor-creditor balance and more about whether the rules should be consistent, whether or not a trust is employed. Seven states have moved to create exemptions for inherited IRAs to negate the trust advantage.

Now that inherited IRAs are not exempt in bankruptcy, estate planners and IRA custodians will develop and push IRA benefits trusts and discretionary spendthrift trusts that will circumvent the ruling. As chronicled in the RSM article referenced above, such trusts should be carefully drafted to comply with the applicable Treasury regulations and state law. There are income and estate tax issues as well as asset protection considerations that have to be addressed. Taxpayers should review trusts designed to hold retirement assets to ensure that the Regulations and trust laws are followed and consult with their tax advisors on the optimal approach for their particular situations.

This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services.  This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein.  RSM LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person.

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