No Bankruptcy Law Protection for Inherited IRAs

Last week, in Rameker v. Clark, the 7th Circuit Court of Appeals ruled that assets held in an inherited IRA are not exempt assets in a bankruptcy court proceeding. This is important for parents and beneficiaries of their IRAs to understand. This ruling clarifies the law on this point, at least for Wisconsin and Illinois, which are states subject to decisions from the 7th Circuit.

This ruling is unique and important. First, if money is in a participant's IRA, the money is an exempt asset in a bankruptcy proceeding pursuant to sections 522(b)(3)(C) and (d)(12) of the bankruptcy code. This exemption is critically important. If a person files for bankruptcy protection and has an IRA, the balance of the IRA is exempt from creditor attack and does not need to be used to pay creditors. The recent court ruling specifically addresses whether the creditor protection extends to an inherited IRA.

For example, parent names child 1 and child 2 as equal primary beneficiaries of his $500,000 IRA. Parent dies. Child 1 and child 2 each inherit an IRA worth $250,000. Child 1 subsequently files a bankruptcy petition. The precise issue before the court was whether the bankruptcy trustee could force child 1 to use the IRA to pay creditors. The 7th Circuit ruled that the bankruptcy trustee could take the assets of the IRA to pay creditors.

The case in question originated in the Western District of Wisconsin. Heidi Heffron-Clark inherited a $300,000 IRA from her mother, Ruth Heffron. The court reasoned that once the IRA was inherited by Heidi, the funds in the IRA were no longer retirement funds. While Heidi's mother was alive, the IRA represented retirement funds, "but when she died they became no one's retirement funds." To the court, the funds in the IRA "represented an opportunity for current consumption, not a fund of retirement savings."

The Clark decision will have a ripple effect. There are likely many pending bankruptcy cases in the 7th Circuit that will be impacted. In addition, the opinion of the 7th Circuit conflicts with opinions from the 8th and 5th Circuits. Consequently, the U.S. Supreme Court will likely eventually grant certiorari to a case to decide this issue on a national basis.

From an estate planning perspective, if a child has creditor issues, and that child is the likely beneficiary of a retirement account, it may be logical for the parent to designate a trust as the beneficiary of the retirement account.  With a properly drafted trust as the beneficiary, the IRA would be exempt from creditor attack.  Heidi Heffron-Clark may be wishing her mother would have considered this type of planning before her death.  Instead, she is now faced with using the $300,000 in the inherited IRA to pay her and her husband's creditors or appealing her case to the U.S. Supreme Court.