This recent Supreme Court case
will have a major impact on IRA planning. You must now set up an IRA trust if you want any chance to protect these assets from creditors once they go to a beneficiary.
When petitioners filed for Chapter 7 bankruptcy, they sought to exclude roughly $300,000 in an inherited individual retirement account (IRA) from the bankruptcy estate using the "retirement funds" exemption. See 11 U.S.C. §522(b)(3)(C) . The Bankruptcy Court concluded that an inherited IRA does not share the same characteristics as a traditional IRA and disallowed the exemption. The District Court reversed, explaining that the exemption covers any account in which the funds were originally accumulated for retirement purposes. The Seventh Circuit disagreed and reversed the District Court.
Funds held in inherited IRAs are not "retirement funds" within the meaning of §522(b)(3)(C). (a) The ordinary meaning of "retirement funds" is properly understood to be sums of money set aside for the day an individual stops working. Three legal characteristics of inherited IRAs provide objective evidence that they do not contain such funds. First, the holder of an inherited IRA may never invest additional money in the account. 26 U.S.C. §219(d)(4). Second, holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. §§408(a)(6), 401(a)(9)(B). Finally, the holder of an inherited IRA may withdraw the entire balance of the account at any time — and use it for any purpose — without penalty.
(b) This reading is consistent with the purpose of the Bankruptcy Code's exemption provisions, which effectuate a careful balance between the creditor's interest in recovering assets and the debtor's interest in protecting essential needs. Allowing debtors to protect funds in traditional and Roth IRAs ensures that debtors will be able to meet their basic needs during their retirement years. By contrast, 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. The "retirement funds" exemption should not be read in a manner that would convert the bankruptcy objective of protecting debtors' basic needs into a "free pass," Schwab v. Reilly, 560 U.S. 770 , 791.
(c) Petitioners' counterarguments do not overcome the statute's text and purpose. Their claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for retirement, conflicts with ordinary usage and would render the term "retirement funds," as used in §522(b)(3)(C), superfluous. Congress could have achieved the exact same result without specifying the funds as "retirement funds." And the absence of the phrase "debtor's interest," which appears in many other §522 exemptions, does not indicate that §522(b)(3)(C) covers funds intended for someone else's retirement. Where used, that phrase works to limit the value of the asset that the debtor may exempt from her estate, not to distinguish between a debtor's assets and the assets of another.
Also unpersuasive is petitioners' argument that §522(b)(3)(C) 's sentence structure i.e., a broad category, here, "retirement funds," followed by limiting language, here, "to the extent that"-prevents the broad category from performing any independent limiting work. This is not the only way in which the phrase "to the extent that" may be read, and this argument reintroduces the problem that makes the term "retirement funds" superfluous.
Finally, 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. You will hear a lot about unprotected inherited IRAs in the near future.