Bankruptcy and An Inherited IRA

In bankruptcy, an Individual Retirement Account (IRA) is usually protected from creditors. But controversy has been brewing over protection for an IRA when it is inherited from another person.

When you establish an IRA, you can provide for it to be paid to someone else upon your death. If that person is not a spouse, there are complex tax rules that allow the funds to be sheltered in their own separate account but they do require the beneficiary to start taking distributions soon after.

The distribution of the IRA has nothing to do with age or employment status, as a retirement plan normally might. That’s where the issue has arisen. Some bankruptcy courts concluded that federal exemptions require that an IRA be funded by the debtor’s own retirement funds and be created and tax sheltered. Since an Inherited IRA is created under Sec. 402 (although tax sheltered by Sec. 408) and the funds used to create the IRA were not the debtor’s own retirement contributions then they are not protected in bankruptcy.

The bankruptcy appeals court disagreed. Instead of looking subjectively at who contributed the funds and whether they were retirement funds of the debtor, they concluded an objective analysis should be applied.

The federal bankruptcy exemption only requires it be retirement funds — which they were when contributed – not that they specifically have been funded by the debtor with his or her own funds. To do otherwise would virtually delete a provision of bankruptcy law that also protects IRA accounts when funded by rollover money from another IRA.

The other crucial factor is that an Inherited IRA is sheltered from tax under the same provisions as a regular IRA. It is irrelevant that the debtor will have to take early distributions since the exemption itself does not make an exception for those situations. In reality, this makes sense.

Congress amended the bankruptcy law in 2005 with mostly anti-consumer provisions. But one pro-consumer provision of the U.S. Bankruptcy Code protected IRAs and retirement fund assets. And it did so broadly — creating only a cap of $1 million and even this cap can be waived by a court in the “interests of justice.” Congress even took the unusual step of — for the first time — trampling on states’ rights by forcing protection for IRAs even where the states did not do so on their own.

While an Inherited IRA is not itself created with retirement money taken from the debtor, it’s standard financial advice to take into account potential inheritances. Reasonable consumers who have good reason to expect a large inheritance may quite rationally spend funds they would otherwise save if they know they will receive a nest egg from a wealthy cousin’s own estate at some point. It would make sense to spend more to, for example, pay for a child’s education at a better college than sock the tuition away in an IRA and send the kid to community college — while also expecting to inherit a large fund in the future.

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