Q: When is a retirement account not a retirement account?
A: When it's an inherited IRA and the owner is bankrupt.
That's what the Supreme Court said last week in a case involving the Bankruptcy Code's exemption for "retirement funds." (The case is Clark v. Rameker, No. 13-299.) In general, when an individual files bankruptcy, funds that are set aside for his or her retirement can be excluded from the bankruptcy estate, which means that they are not available to be paid to creditors. Once the bankruptcy is settled, those "retirement funds" remain available for the individual to use in retirement, so that he or she will not be destitute. The exemption applies to "retirement funds" that are in a fund or account that is tax-exempt under certain enumerated sections of the Internal Revenue Code, including sections 408 and 408A (the sections that apply to IRAs and Roth IRAs, respectively).
So, even though the Bankruptcy Court had incorrectly held that an inherited IRA is not an account that is tax-exempt under one of the enumerated sections – it is exempt from tax under the same sections as any other IRA – the Supreme Court did not have to reach that issue. Instead, the Court determined that the inherited IRA did not consist of "retirement funds" at all, so it was unnecessary to determine whether they were held in the right type of account. Unlike other IRAs, which are designed so that the funds cannot be withdrawn – or cannot be withdrawn without penalty – until the individual has reached a reasonable retirement age, funds in an inherited IRA can be withdrawn without penalty at any time. In fact, the funds in an inherited IRA are usually required to be currently withdrawn (by the "required minimum distribution" rules of the Internal Revenue Code).
The Court then noted that the purpose of the "retirement funds" exemption is to preserve a debtor's ability to meet basic needs in retirement without enjoying a cash windfall at the expense of his or her creditors. To the contrary, the Court said, an inherited IRA's legal characteristics do nothing to prevent or even to discourage using the entire IRA balance to purchase a vacation home or a sports car immediately after the bankruptcy proceedings are complete. That would transform the Bankruptcy Code's exemption from a "fresh start" into a "free pass."
After discussing and rejecting a few additional less-than-impressive arguments in favor of applying the exemption, the Court affirmed the Seventh Circuit's holding, and determined that inherited IRAs are not "retirement funds" under the Bankruptcy Code, and are not eligible for exclusion as such from debtors' bankruptcy estates.