The bankruptcy code exists to ensure the orderly resolution of situations where the debts and obligations of an individual exceed their assets and their ability to pay their creditors. As a matter of public policy, though, the function of bankruptcy is not merely to facilitate the liquidation of an individual's assets to satisfy their debts, but also the determination of what assets should be protected/exempted even in bankruptcy to allow them to maintain a basic standard of living, in recognition that truly forcing people to liquidate all of their assets to satisfy their debts may simply leave them impoverished wards of the state, ultimately relying on the government and fellow taxpayers for support. Accordingly, the bankruptcy code often protects key assets like a personal residence/homestead, along with retirement accounts.

In the new Supreme Court decision of Clark v. Rameker, though, the courts have acknowledged that while the bankruptcy code is intended to protect the retirement accounts of debtors, it is not meant to protect the inherited IRAs that debtors may have been bequeathed by someone else who, by definition, will clearly no longer be using it for their own retirement. Noting that inherited IRAs do not permit contributions, have ongoing distribution requirements regardless of age and retirement, and have no early withdrawal penalties associated with them, the unanimous Supreme Court decision acknowledged that inherited IRAs are effectively "freely consumable" by the beneficiary, and thus should be freely available to the creditors of the beneficiary as well.

For those who were counting on the bankruptcy code to protect an inherited IRA, the Supreme Court decision will now leave them exposed. From a proactive planning perspective, the Clark decision will likely make it far more appealing for spousal beneficiaries to roll over inherited retirement accounts rather than leaving them as inherited IRAs, and non-spouse beneficiaries may increasingly prefer to inherit retirement accounts via a trust on their behalf, taking advantage of the "see-through" trust regulations to ensure the inherited IRA can still stretch its distributions to the trust itself. On the other hand, the acknowledgement by the Supreme Court that a retirement account effectively ceases to be a preferential account (for asset protection purposes at least) after the death of the original owner also raises the question of whether Congress' recent proposals to curtail the use of stretch IRAs altogether and force most beneficiaries to use the 5-year rule may soon come to pass as well!

The Supreme Court Case Of Clark v. Rameker

The case of Clark v. Rameker involved a Wisconsin couple (Heidi Heffron-Clark and her husband Brandon Clark) who declared bankruptcy in 2010, and in their bankruptcy filing claimed that the remaining (approximately $300,000) balance of an inherited IRA that Heidi inherited from her mother Ruth back in 2001 should be protected under 11 USC 522(b)(3)(C) of the Bankruptcy code, which protects retirement accounts of various types (as of changes implemented under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005). This protection of the retirement account was challenged by the bankruptcy trustee William Rameker (on behalf of creditors Resul and Zinije Adili), on the basis that an inherited IRA should not be treated as a retirement account for bankruptcy protection after the original IRA owner had passed away. Initially, the bankruptcy court sided with Rameker, but the District Court reversed the decision, and the Seventh Circuit Court of Appeals disagree again (siding with the original Rameker ruling and not the district court). Because the Seventh Circuit's decision disagree with prior decisions in the Eighth Circuit (In re Nessa) and the Fifth Circuit (In re Chilton), the Supreme Court agreed last November to hear the case, and the Clark v. Rameker ruling was issued last week on June 12th.

Throughout the case, the core issue remained whether an inherited IRA retains its character as a "retirement account" for the purposes of bankruptcy protection. The original bankruptcy court ruling held that the account was no longer a true "retirement" account after the death of the original IRA owner (who by definition no longer needed retirement funds!), while the District Court that overturned the decision held that since the account was originally accumulated for retirement purposes and the funds were still in the account, that they should still be treated as retirement funds for bankruptcy purposes as well. The Appeals court insisted that since the inherited IRA can be consumed immediately, and does not need to be held for future use as a retirement fund (as there is no early withdrawal penalty for inherited IRAs as there is for the original owner of the IRA), it is no longer a retirement account; in other words, if the owner of the inherited IRA is allowed to consume the account freely, it should be available to that person's creditors, too.

Ultimately, the Supreme Court agreed with the Appeals court, and in a unanimous decision declared that an inherited IRA will not be treated as "retirement" funds for the purposes of bankruptcy protection, and thus the assets will be available to creditors. In writing for the court, Justice Sotomayor noted three key distinguishing factors for  why inherited IRAs should not receive protection as retirement accounts: 1) inherited IRA owners cannot contribute to the account as a retirement account (per the limitations of IRC Section 219(d)(4)); 2) inherited IRA owners must take annual withdrawals (required minimum distributions) from the account, which applies regardless of whether they are retired or of retirement age (under IRC Sections 408(a)(6) and 401(a)(9)(B)); and 3) there are no age-related penalties for withdrawals from inherited IRAs (i.e., the normal Section 72(t)(1) early withdrawal penalty does not apply to distributions from inherited IRAs). Thus, the Supreme Court substantively agreed with the Appeals Court, that "nothing about an inherited IRA's legal characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for purposes of current consumption" and "the possibility that an account holder can leave an inherited IRA intact until retirement and take only the required minimum distributions does not mean that an inherited IRA bears the legal characteristics of retirement funds. Therefore, the "retirement funds" bankruptcy exemption should not apply.

Planning Implications Of The Clark Supreme Court Decision

The most immediate implication of the Clark v. Rameker Supreme Court decision is rather straightforward: an inherited IRA will not be eligible for bankruptcy protection (unless there is a separate state law providing such protection). For an individual who includes an inherited IRA as part of their assets, declaring bankruptcy will mean that inherited IRA is potentially on the table to be liquidated to satisfy creditors, just as with any other (non-exempt) asset. Of course, once an inherited IRA has been inherited, there's little else that can be done - liquidating or trying to move the inherited IRA would just trigger immediate income tax consequences anyway, and still not leave the account protected. From a practical perspective, this simply means that anyone who is concerned about asset protection and the risks of being exposed to creditors will need to look to alternatives - such as protecting other assets so at worst the only funds a creditor can reach is the inherited IRA, and/or simply trying to maintain enough liability insurance to cover most/all risks in the first place (so that it never comes to bankruptcy and a forced liquidation of assets anyway).

On the other hand, the ruling does imply that a spouse's inherited IRAs really may benefit from greater asset protection by rolling it over into their own name (where the assets are then treated like any other individual retirement account, and ostensibly will enjoy the full bankruptcy protections for retirement accounts), rather than leaving the funds as an inherited IRA (to the extent such asset protection is a concern in the first place). Though it's still possible that the courts may eventually decide that a spouse's IRA funds "sourced" from an inherited IRA could still be subject to bankruptcy creditors, and trying to roll over an inherited IRA to a spouse's own IRA in the midst of a legal proceeding could be deemed a fraudulent conveyance.

From the proactive planning perspective, the biggest implication of the inherited IRA ruling is that, for those who are concerned about asset protection, more careful thought should be given to how retirement assets are bequeathed in the first place. To some extent, this may make inherited an employer retirement plan more appealing, as the inheritor may still be able to claim ERISA protection for the inherited 401(k)/profit-sharing plan/etc. However, it remains to be seen whether ERISA protection for retirement accounts might someday also be challenged (on the same grounds that an inherited account should no longer benefit from protection for "retirement" accounts), and from a practical perspective many inherited employer retirement plans don't allow beneficiaries to stretch in the first place and instead force funds out under the 5-year rule (which means even if inherited employer retirement plans are protected, they won't stay that way for long!). While all inherited employer retirement plans are required to allow a trustee-to-trustee transfer to an inherited IRA to permit a stretch for a designated beneficiary (since 2009 under the Worker, Retiree, and Employer Recovery Act [WRERA] of 2008), doing so for stretch purposes will then revert the account to inherited IRA status and lose asset protection.

Trusts As Beneficiaries Of IRAs

Given all of these challenges, perhaps the most direct outcome of the Clark ruling on inherited IRAs is that, for situations where asset protection for beneficiaries is paramount, the use of a trust as the beneficiary for an inherited IRA will become more popular than ever. After all, notwithstanding the bankruptcy exemption - or lack thereof - for an inherited IRA itself, if an IRA is left to a third-party trust and the subsequent beneficiary is simply the beneficiary of a trust to which they have limited access and control, all assets of the trust - including the inherited IRA that was left to it - can enjoy robust protection (assuming the usual rules for third-party asset protection trusts are met).

Of course, to avoid unfavorable income tax treatment, it will still be crucial that the trust-as-beneficiary is structured in a manner that complies with the requirements of Treasury Regulation 1.401(a)(9)-4, Q&A-5, so that the trust can stretch distributions from the inherited IRA over the life expectancy of the underlying individual beneficiaries. Nonetheless, there is nothing directly conflicting between the requirements for a trust to be a beneficiary and still enjoy "see-through" treatment to stretch, and the use of a trust as IRA beneficiary for asset protection purposes. The approach simply means that the trust will be expected to accrue the required minimum distributions from the inherited IRA on behalf of the beneficiary, and not (necessarily) pass them through (where they would once again become subject to creditors of the beneficiary).

Unfortunately, accumulating inherited IRA distributions at the trust level and not passing them through will have less favorable income tax treatment; while inherited IRA distributions can be stretched over the life expectancy of the underlying trust beneficiaries (if the requirements are met), distributions that are not passed through and are held at the trust level will be reported on the trust's tax return and subject to compressed trust tax brackets. With a top tax bracket of 39.6% kicking in at only $12,150 of taxable income (in 2014), pursuing such a trust-based asset protection strategy will represent an unfortunate trade-off of less favorable tax consequences in exchange for more favorable asset protection treatment (as if the beneficiary of the IRA was named directly, it would be taxed at his/her more favorable rates, but after Clark such an approach no longer enjoys asset protection!).

Unintended Consequences: New 5-Year Limit On Stretch IRAs For All?

One of the potentially notable "unintended consequences" of the Clark decision is the potential impact that it may have on the ability to stretch an inherited IRA after death in the first place.

After all, the reality is that Congress has already indicated for several years that it is considering whether to end the favorable post-death stretch treatment for inherited IRAs. As previously noted on this blog, the possibility of eliminating stretch IRAs and forcing most beneficiaries under the 5-year rule (with some exceptions for young children, disabled beneficiaries, and spouses) was first proposed as potential legislation back in 2012, and appeared again more recently in the Treasury Green Book of the President's budget proposals. While many planners have expressed concern that such a change could have adverse income tax consequences - as potentially large inherited IRAs may have to be liquidated fairly quickly, driving the beneficiaries into higher tax brackets as the withdrawals are taken - the response from legislators has been that the tax preferences for retirement accounts are specifically intended to benefit retirees, not necessarily the beneficiaries of those who inherit from retirees that didn't use all their retirement funds.

Accordingly, the Clark ruling here seems to re-affirm, albeit in a different context, that retirement accounts do not deserve all of their favorable treatment as retirement accounts after the death of the original retirement account owner, as once the funds become "inherited" they're not substantively different than any other fully liquid, freely consumable inherited assets (beyond the fact that they are Income in Respect of a Decedent and that the income taxes on the pre-tax growth will still be due). If retirement accounts cease to be retirement accounts for asset protection and bankruptcy purposes after the death of the owner, does that mean the days are numbered for the favorable income tax treatment afforded to retirement accounts after the death of the retirement owner too? We'll see.

In any event, the bottom line is that most beneficiaries are not at high risk for liability and creditors in the first place, and/or have other assets and liability insurance to protect them in the event that there is a financial issue. But for those where asset protection is a priority, the new Supreme Court ruling means that prospective planning for inherited IRAs will likely involve far more frequent use of trusts, or possibly an effort to bequeath inherited employer retirement plans eligible for ERISA protection, rather than relying on the protections for retirement accounts alone. And in the meantime, it remains to be seen whether the Clark decision impacts other rules - like the favorable treatment for stretch IRAs - as well.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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