Retirement Accounts in Bankruptcy

Generally speaking, retirement accounts are exempt when you file for bankruptcy including:

11 U.S.C. § 522 – Tax exempt retirement accounts (including 401(k)s, 403(b)s, profit-sharing and money purchase plans, SEP and SIMPLE IRAs, and defined benefit plans).

11 U.S.C. § 522(b)(3)(C)(n) – IRAS and Roth IRAs to $1,171,150.

State Pers. & Pen. 21-502 – State employees

11-504 – ERISA-qualified benefits, including IRAs, Roth IRAs and Keoghs.

However there are exceptions. What happens when an IRA owner dies and the account is inherited by a person who later files for bankruptcy? Can the holder of the inherited IRA benefit from the IRA bankruptcy exemption? The United States Supreme Court says that, where the beneficiary is a person other than the account owner’s spouse, the answer is “no.”The Supreme Court case called Clark v. Rameker concerned a woman who inherited $450,000 from her mother’s IRA in 2001 and filed for bankruptcy nine years later with $300,000 of the funds remaining.

Upon closer inspection, there are a number of reasons why inherited IRAs should not be considered retirement accounts. The Supreme Court said these factors outweighed any counter arguments.

• Beneficiaries cannot add money to inherited IRAs like IRA owners can to their accounts.

• Beneficiaries of inherited IRAs must generally begin to make required minimum distributions (RMDs) in the year after they inherit the accounts, regardless of how far away they are from retirement.

• Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty. IRA owners must generally wait until age 59 ½ before they can take penalty-free distributions.

Pointing to these distinctions, the Supreme Court determined that inherited IRAs do not contain funds dedicated exclusively for use by individuals during retirement. As a result, the favorable bankruptcy protection afforded to retirement funds under the federal bankruptcy code does not apply.

SPOUSAL INHERITANCE

The decision has important ramifications for spouses. Spouses who inherit IRAs have an option not available to other inheritors. They can roll the assets into their own IRAs and postpone distributions from the traditional IRA until age 70 ½. The catch is, like other IRA owners, they may have to pay a 10% early-withdrawal penalty if money is taken before age 59 ½. Unless the rollover is done however, the accounts are considered inherited IRAs and those assets will not be protected in bankruptcy. Although the court did not rule specifically on the impact of a spousal rollover on creditor protection, a convincing argument can be made that a rolled-over IRA — with the funds designated for retirement funding — deserves the same level of protection as when it was in the original owner’s hands.