Supreme Court rules inherited IRAs not protected from creditors

July, 15 2014 by Carolyn Richardson, EA, MBA

In all the hoopla surrounding the Supreme Court’s decision in the Hobby Lobby case, it probably escaped everyone’s notice that the Court issued an earlier decision on June 14, 2014, regarding whether inherited IRAs are protected when a taxpayer declares bankruptcy, or from other claims of creditors. This decision is likely to impact many taxpayers, particularly anyone expecting to inherit an IRA from a parent or someone else.

The case, Clark v. Rameker, involved a taxpayer who had filed for bankruptcy. Under the bankruptcy code, certain “retirement funds” are exempt from the bankruptcy estate. In other words, these accounts are not considered to be assets that can be used to pay off creditors if you have to declare bankruptcy. Both traditional and Roth IRAs are normally exempt from bankruptcy.

If your spouse dies and you inherit their IRA, you have the option of rolling over the funds to your own IRA, and at that point it becomes your IRA. Any distributions you make from that IRA are treated the same as they would if you had put the money into the account yourself. If you inherit the IRA from someone other than your spouse, though, you only have the option of holding the account as an inherited IRA, taking Required Minimum Distributions each year or withdrawing all of the funds within 5 years of your benefactor’s death. The holder of an inherited IRA may withdraw funds from the IRA at any time and for any reason, at any age, without paying the 10% early distribution penalty.

In the Clark case, Heidi Heffron-Clark inherited an IRA worth $450,000 from her mother, who died in 2001. In 2010, she and her husband declared bankruptcy when the account was worth $300,000. They sought to exempt this account from their bankruptcy estate, and their creditors filed an objection. Several appeals courts disagreed with each other, which is why it ended up at the Supreme Court.

The Supreme Court agreed with the 7^th Circuit’s earlier decision that “inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.” In other words, the beneficiary of an inherited IRA can withdraw money at any time for any reason, not just for retirement.

So, if you have an inherited IRA and are thinking of claiming bankruptcy, keep this in mind. Those funds can be used by the bankruptcy estate to pay off debt. If the funds would be enough to pay off your debts, you might as well use them that way and avoid bankruptcy completely and the credit ramifications that come with it.