Most Americans don’t save enough money for retirement. However, the Supreme Court recently dealt with the opposite situation—what happens when someone saves more than they need and their heirs receive the money (and then file bankruptcy).
This is the third time that the high court has considered what happens to retirement funds in bankruptcy. In Patterson v. Shumate, 504 U.S. 753 (1992), the Court held that funds in an employer's pension plan were not property of the estate [an enhanced version of this opinion is available to lexis.com subscribers]. In Rousey v. Jacobsen, 544 U.S. 320 (2005), the Court ruled that non-inherited IRAs were included under the exemption for “a stock bonus, pension, profit sharing, annuity, or similar plan or contract” under 11 U.S.C. §522(d)(10)(E) [enhanced version]. This time, the Court held that an inherited IRA does not constitute “retirement funds” under 11 U.S.C. §522(b)(3)(C) and 522(d)(12). Clark v. Rameker, Trustee, No. 13-299 (6/12/14). The opinion can be found here [enhanced version].
While the opinion denies the exemption under two subsections of the Bankruptcy Code, it does not address exemptions under state law. As will be discussed below, this makes a big difference for Texas debtors.
The facts are pretty straightforward. Ruth Heffron established a traditional IRA in 2000 and passed away the next year. Her daughter and beneficiary, Heidi Heffron-Clark, received the IRA and elected to take monthly distributions from it. In October 2010, she and her husband filed bankruptcy. She claimed the $300,000 in the inherited IRA under both Wisconsin law and 11 U.S.C. §522(b)(3)(C). The Bankruptcy Court ruled against her on both grounds. In re Clark, 450 B.R. 858 (Bankr. W. D. Wisc. 2011) [enhanced version]. The District Court reversed, but the Seventh Circuit reinstated the Bankruptcy Court’s ruling. In re Clark, 714 F.3d 559 (7th Cir. 2013) [enhanced version]. The Supreme Court granted cert to resolve the conflict between the Seventh Circuit and the Fifth Circuit’s decision in In re Chilton, 674 F.3d 486 (5th Cir. 2012) [enhanced version].
Exemption Statutes and Types of IRAs
Retirement accounts can be broken into two main categories: employer plans and individual retirement accounts (IRAs). Employer plans are required to contain anti-alienation language which the Supreme Court previously held was sufficient to keep them from ever becoming property of the estate.
IRAs do not have the same anti-alienation protection. As a result, they come into the bankruptcy estate and only come out if there is an applicable exemption statute. Prior to 2005, IRAs could be exempted under state law under 11 U.S.C. §522(b)(3)(A) or under 11 U.S.C. §522(d)(10) in the handful of states that permitted use of the federal exemptions. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress allowed Debtors electing state or federal exemptions to claim:
retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.
11 U.S.C. §522(b)(3)(C) and (d)(12). The effect of this amendment was that all debtors could keep those funds so long as they were “retirement funds” and were in a fund or account exempt from taxation under the listed sections of the Internal Revenue Code.
IRAs are governed by 26 U.S.C. §§408 and 408A. As a result, they fall within the enumerated sections. According to the Supreme Court, there are three types of IRAs. Under a conventional IRA, contributions are tax deductible, while under a Roth IRA, qualified distributions are tax free. Both types of accounts are subject to a 10% penalty if funds are withdrawn prior to age 59 ½. (Remember when you were a kid and you were quick to point out that you were 7 ½ as opposed to just 7? With IRAs, your half-birthday becomes important once again).
The third type of IRA is an inherited IRA. If the beneficiary is the deceased’s spouse, they can roll the funds over into their own IRA account in which case, they become part of the conventional or Roth IRA. However, if the beneficiary is not a spouse or if the spouse elects not to take the roll over, they can be treated as an inherited IRA. Funds can be withdrawn from an inherited IRA at any time without penalty. The beneficiary must either withdraw all of the funds within five years or elect to take minimum distributions on an annual basis. The beneficiary cannot make additional contributions into the account.
The Supreme Court’s Ruling
Engaging in its role as dictionary of last resort, Justice Sonia Sotomayor’s opinion explored what it meant for funds to be “retirement funds.” Because the relevant statutes do not define “retirement funds,” the court attempted to divine the term’s “ordinary meaning.” Opinion, p. 4.
Justice Sotomayor found three reasons why inherited IRAs were not “retirement funds”:
Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement. First, the holder of an inherited IRA may never invest additional money in the account. 26 U. S. C. §219(d)(4). Inherited IRAs are thus unlike traditional and Roth IRAs, both of which are quintessential “retirement funds.” For where inherited IRAs categorically prohibit contributions, the entire purpose of traditional and Roth IRAs is to provide tax incentives for accountholders to contribute regularly and over time to their retirement savings.
Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement. Under the Tax Code, the beneficiary of an inherited IRA must either withdraw all of the funds in the IRA within five years after the year of the owner’s death or take minimum annual distributions every year. See §408(a)(6); §401(a)(9)(B); 26 CFR§1.408–8 (Q–1 and A–1(a) incorporating §1.401(a)(9)–3 (Q–1 and A–1(a))). Here, for example, petitioners elected to take yearly distributions from the inherited IRA; as a result, the account decreased in value from roughly$450,000 to less than $300,000 within 10 years. That the tax rules governing inherited IRAs routinely lead to their diminution over time, regardless of their holders’ proximity to retirement, is hardly a feature one would expect of an account set aside for retirement.
Finally, the holder of an inherited IRA may with draw the entire balance of the account at any time—and for any purpose—without penalty. Whereas a withdrawal from a traditional or Roth IRA prior to the age of 59½ triggers a 10 percent tax penalty subject to narrow exceptions, see n. 4, infra—a rule that encourages individuals to leave such funds untouched until retirement age—there is no similar limit on the holder of an inherited IRA. Funds held in inherited IRAs accordingly constitute “a pot of money that can be freely used for current consumption,” 714 F. 3d., at 561, not funds objectively set aside for one’s retirement.
Opinion, pp. 5-6.
Because “plain meaning” analysis is never quite so plain as its proponents contend (especially if the case has made its way to the Supreme Court), the Court buttressed its ruling with policy considerations. Among them, the purpose of an exemption is to allow the debtor to meet “essential needs.” Encouraging (although not requiring) debtors to keep their funds in an IRA until after age 59 ½ sort of aligns with the goal of ensuring that debtors have sufficient funds to support themselves in their golden years and do not become a burden on society. On the other hand, inherited IRAs can be freely withdrawn and could be used on “a vacation home or sports car immediately after her bankruptcy proceedings are complete.” Opinion, p. 7. This conclusion seems a bit strained. Funds in a conventional or Roth IRA could also be used for wild living once the bankruptcy was over; it’s just that there would be tax consequences if the person was under age 59 ½. Further, in an age when the full retirement age is 67 and rising, being allowed to utilize fund at age 59 ½ means that they will likely be used as a stopgap to carry the person to retirement rather than funding actual retirement costs.
Another factor which was not mentioned in the opinion was that the Debtors had $300,000 in the inherited IRA and had unsecured debts scheduled of $311,000. As a result, the Debtors could have used the funds to settle with their creditors and likely had money left over. Instead, they tried to file bankruptcy and keep it all. While there is nothing wrong with using the tools made available by the law, avoiding a windfall to the Debtors at the expense of the creditors could have been rolling around in the back of the justices’ minds.
Thus, inherited IRAs cannot be retained in a bankruptcy proceeding—except for the cases in which they can.
What It Means
The Court’s opinion only addressed 11 U.S.C. §522(b)(3)(C) and (d)(12). It did not address either exemptions under applicable state law. In the Clark case, the Bankruptcy Court had ruled that Wisconsin law did not include an exemption for inherited IRAs. However, the relevant Texas statute provides:
(a) In addition to the exemption prescribed by Section 42.001, a person's right to the assets held in or to receive payments, whether vested or not, under any stock bonus, pension, annuity, deferred compensation, profit-sharing, or similar plan, including a retirement plan for self-employed individuals, or a simplified employee pension plan, an individual retirement account or individual retirement annuity, including an inherited individual retirement account, individual retirement annuity, Roth IRA, or inherited Roth IRA, or a health savings account, and under any annuity or similar contract purchased with assets distributed from that type of plan or account, is exempt from attachment, execution, and seizure for the satisfaction of debts to the extent the plan, contract, annuity, or account is exempt from federal income tax, or to the extent federal income tax on the person's interest is deferred until actual payment of benefits to the person under Section 223, 401(a), 403(a), 403(b), 408(a), 408A, 457(b), or 501(a), Internal Revenue Code of 1986, including a government plan or church plan described by Section 414(d) or (e), Internal Revenue Code of 1986. For purposes of this subsection, the interest of a person in a plan, annuity, account, or contract acquired by reason of the death of another person, whether as an owner, participant, beneficiary, survivor, coannuitant, heir, or legatee, is exempt to the same extent that the interest of the person from whom the plan, annuity, account, or contract was acquired was exempt on the date of the person's death. If this subsection is held invalid or preempted by federal law in whole or in part or in certain circumstances, the subsection remains in effect in all other respects to the maximum extent permitted by law. (emphasis added).
Tex.Prop.Code §42.0021(a). The language specifically including inherited IRAs was added to the statute in 2013 after a Texas Bankruptcy Court concluded that inherited IRAs were not exempt under state law. In re Jarboe, 365 B.R. 717 (Bankr. S. D. Tex. 2007) [enhanced version]. (Given the dysfunctional nature of the Texas legislature, Judge Bohm should be proud of the fact that his opinion prompted them to do something, even if it was to legislatively overrule his decision). The fact that the Texas legislature amended the statute to add specific language about inherited IRAs is pretty good evidence that they really intended these accounts to be exempt.
The practice tips for Texas debtors are:
Hat-tip to Quincy Long with Quest IRA, Inc. who pointed out the new language in the Texas Property Code to me.
Read more at A Texas Bankruptcy Lawyer's Blog
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