All 9 justices agree that an IRA is transferred to a beneficiary by death of the original owner is no longer protected from creditors.
A month ago the U.S. Supreme Court delivered a decision important for anybody considering bankruptcy who has an Individual Retirement Account (IRA). Since about 40% of the nation’s households have an IRA, this Supreme Court opinion affects a tremendous number of people.
Also, since the Supreme Court decides very few cases about consumer bankruptcy, when it speaks we listen.
The Clark v. Rameker Opinion
In this case the Court ruled that a woman’s IRA, inherited from her mother years earlier, was not protected from her creditors when she filed a Chapter 7 bankruptcy case.
The woman, Heidi Heffron-Clark, and her husband, Brandon Clark, had operated a pizza parlor which failed during the recent recession. In 2010 they filed a Chapter 7 “straight bankruptcy” case in Madison, Wisconsin.
Many years earlier Heidi’s mother had set up a traditional IRA for herself, with Heidi as the sole beneficiary. Heidi’s father then died at the age of 52, and his IRA was rolled into Heidi’s mother’s IRA. Then Heidi’s mother died at the age of 56, so her IRA passed to Heidi as the designated beneficiary. Nine years later when the couple filed their bankruptcy case, they designated this IRA as “exempt”—protected from their creditors—under the provision in the Bankruptcy Code exempting “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section . . . 408 [pertaining to IRAs].”
But their Chapter 7 trustee, William Rameker, acting on behalf of Heidi and Brandon’s creditors, objected to their claim of exemption. He argued that an IRA that is inherited is not a “retirement fund” for purposes of the bankruptcy exemption.
The Lower Court Decisions
The Wisconsin bankruptcy judge ruled in favor of the trustee.
But when Heidi and Brandon appealed this ruling to the Federal District Court for the Western District of Wisconsin, the judge there ruled in their favor, overturning the bankruptcy judge.
However, when the trustee appealed that decision to the Seventh Circuit Court of Appeals (which covers the federal courts in Wisconsin, as well as Indiana and Illinois), he won again. A panel of three judges ruled that the bankruptcy judge had been right in the first place.
So Heidi and Brandon appealed to the Supreme Court, which agreed to hear and decide the case because another Circuit Court, in Texas, had earlier ruled in the opposite way. The Supreme Court tends to hear cases to resolve conflicts between different circuit courts.
The Language of the Retirement Exemption Statute
The legal issue for the Supreme Courts, and all these lower court, was the interpretation of just two words in the Bankruptcy Code: “retirement funds.”
As indicated above the Code says that “retirement funds” are exempt “to the extent that those funds are in a fund or account that is exempt from taxation under section . . . 408 . . . of the Internal Revenue Code. . . .” (Section 408 of the Internal Revenue Code is all about IRAs.)
Whether the inherited IRA that Heidi owned at the time the Chapter 7 case was filed continued to be “exempt from taxation under section . . . 408 . . . of the Internal Revenue Code” may have been unresolved. But instead the Supreme Court focused on the separate question whether that inherited IRA was a “retirement fund” in the first place. (If not, the tax-exemption question did not need to be answered.)
What ARE “Retirement Funds”?
The Bankruptcy Code doesn’t define the term.
The Supreme Court determined that the ordinary meaning of “retirement fund” was “sums of money set aside for the day an individual stops working.” It thus looked “to the legal characteristics of the account in which the funds are held, asking whether, as an objective matter, the account is one set aside for the day when an individual stops working.” In other words, even though an inherited IRA is still an IRA (and Individual RETIREMENT Account), beyond the name does it really look and feel like a “retirement fund”?
The Court determined that the following three important characteristics of inherited IRAs are NOT characteristics of a “retirement” account:
- The beneficiaries of an inherited IRA can’t add any money to that account like traditional IRA owners can.
- The beneficiaries of inherited IRAs must begin to take “required minimum distributions” in the year after they inherit the account, no matter how long they are from retirement.
- Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty. They do not have to be retired or any particular age, unlike original IRA owners who must generally wait until 59 ½ before they can take penalty-free distributions.
So, the Supreme Court decided 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 [the] bankruptcy exemption.” So Heidi’s inherited IRA had to be turned over to the Chapter 7 trustee to be distributed to the creditors.