YOUR father’s last will and testament gives you his IRA of $180,000. He died yesterday. Next week you file for Chapter 7 bankruptcy relief because your credit card debt of $40,000 is too much for you to handle. You inform your lawyer of your inherited IRA. Your lawyer tells you, not to worry, because IRA’s are exempt pursuant to Section 522(b)(3)(C) and (d)(12) which states that “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403,408,408A,414,457, or 501(a) of the Internal Revenue Code of 1986.” He tells you that IRA’s meet this requirement. Therefore, your father’s IRA which you inherited is exempt in bankruptcy. The logic seems correct. However, bankruptcy courts are split among the circuits regarding a debtor’s ability to exempt inherited IRA’s.
When a married holder of an IRA dies, his or her spouse inherits the IRA, and can keep it separate or roll it over into his or her own IRA. None of the conditions or attributes of the IRA change as a result of the passing of the IRA from a deceased spouse to the surviving spouse.
It’s a different story when the IRA passes to someone other than a surviving spouse, like from father to son.
In RE CLARK, the debtor inherited her mother’s IRA, which was worth about $300,000. She could not add to it or roll it over into her own IRA. Instead of holding the money for her retirement, the IRS required the debtor to begin taking distributions from the IRA within one year of her mother’s death, and exhaust the account within as little as five years. This is one of the reasons why everyone hates the IRS. Instead of allowing you to keep your parent’s IRA as such, it requires you to use the entire account in 5 years starting year one. They are nasty.
After the debtor and her husband filed for Chapter 7 relief, the bankruptcy court ruled that the inherited IRA was not exempt because it did not constitute “retirement funds” in the debtor’s possession. The court found that “retirement funds” are funds put aside for one’s own retirement. The district court reversed, finding “retirement funds” in the decedent’s hands remain “retirement funds” in the successor’s hands. The 7th Circuit Court of Appeals reversed the district court, and disagreed with the 5th Circuit and the 8th Circuit Bankruptcy Appellate Panel. “Chilton and Nessa give weight to the phrase ‘inherited individual retirement account.’ It includes the word ‘retirement,’ after all. True enough, but the ‘IRA’ part of ‘inherited IRA’ (as the Internal Revenue Code uses the phrase) designates the funds’ source, not the asset’s current status. As we have observed, an inherited IRA does not have the economic attributes of a retirement vehicle, because the money cannot be held in the account until the current owner’s retirement,” the 7th Circuit said. Blame it on the IRS for requiring the exhaustion of the funds within 5 years.
“Chilton and Nessa also give weight to the fact that many of the other exemptions in Section 522 refer to “the debtor’s’ interests, while Section 522(b)(3)(C) and (d)(12) does not. For example Section 422(b)(3)(B) exempts ‘any interest in property in which the debtor had, immediately before the commencement of the case, an interest as a tenant by the entirety or joint tenant to the extent such interest…is exempt from process under applicable non-bankruptcy law.’ This sort of language has a temporal effect: what is exempt is the debtor’s tenancy when the bankruptcy begins… A debtor farmer cannot buy new farm implements after filing for bankruptcy and claim the acquisition as exempt.” However, bankruptcy law gives debtors a break by omitting a temporal restriction: new value added to a retirement fund during bankruptcy (an employer may continue to make retirement contributions) is outside creditors’ reach, even though new real property and new farm tools are not.
The 7th Circuit concluded that the question was not closed, and that the bankruptcy court got it right.
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Lawrence Bautista Yang specializes in bankruptcy, business, real estate and civil litigation and has successfully represented more than five thousand clients in California. Please call Angie, Barbara or Jess at (626) 284-1142 for an appointment at 1000 S Fremont Ave Bldg A-1 Suite 1125 Unit 58 Alhambra, CA 91803.