Treatment of Non-Spousal Inherited IRAs in Bankruptcy

By: Kimberly Tracey

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re Clark, the Court of Appeals for the Seventh Circuit adopted a new approach to the treatment of non-spousal inherited IRAs in bankruptcy cases.  The court reversed the decision of the District Court and found that a debtor could not exempt a non-spousal inherited IRA.[1]  In Clark the debtor sought to exempt an IRA she inherited from creditors’ claims under section 522(b)(3)(C) and (d)(12) of the Bankruptcy Code.[2]  The bankruptcy court held that the inherited IRA was not exempt because the account did not represent retirement funds in the hands of the debtor.[3]  The district court reversed, adopting the view that since the inherited IRA constituted “retirement funds” in the debtor’s mother’s hands, the account must be treated the same way in the debtor’s hands.[4]  Reversing the district court, the Seventh Circuit distinguished a non-spousal inherited IRA as “a time-limited tax-deferral vehicle, but not a place to hold wealth for use after the new owner's retirement.”[5]  Specifically, the Seventh Circuit noted that under the Internal Revenue Code, a non-spousal inherited IRA is subject to mandatory distribution that must begin within a year of the original owner’s death and be completed in no less than five years.[6]  Furthermore, no new contributions may be made to the account.[7]  Consequently, the Seventh Circuit opined that the non-spousal inherited IRA was not a “retirement fund” under the Bankruptcy Code in the hands of the debtor, and as a result, the court held that the non-spousal inherited IRA was not exempt.[8]  In reaching such a holding, the Court declared that “to treat this account as exempt under [section]522(b)(3)(C) and (d)(12) [of the Bankruptcy Code] would allow the debtor to shelter from creditors a pot of money that can be freely used for current consumption.”[9] 

The Seventh Circuit’s holding in Clark is contrary to the majority view that non-spousal inherited IRAs are “retirement funds” that are tax exempt under section 408 of the Internal Revenue Code and, therefore, exempt from the bankruptcy estate under section 522(b)(3)(C) and (d)(12) of the Bankruptcy Code.[10]  Section 522(d)(12) of the Bankruptcy Code provides that a debtor must satisfy two requirements in order to claim the exemption[11]: (1) the funds that the debtor is attempting to exempt must be “retirement funds,” and (2) those funds must be in an account that “is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.”[12]  Although the Bankruptcy Code does not define the term  “retirement funds,” the majority of circuits have held that an inherited IRA falls within the meaning of such term.[13]  For example, in In re Chilton and In re Nessa, the Fifth Circuit and the Eighth Circuit BAP both held that since the non-spousal inherited IRAs were originally set aside for retirement, and were still considered “retirement funds” when inherited by the debtor.[14]  In addition, the Chilton and Nessa courts also held that the transfer of a non-spousal inherited IRA is tax exempt under section 408(e)(1) of the Internal Revenue Code.  That section of the Internal Revenue Code states that “earnings from assets held in an IRA are not subject to taxation in the IRA when earned but rather are subject to taxation when distributions are made.  This fact does not change when the IRA is inherited from the decedent, and therefore the accounts are still exempt.”[15]

The Seventh Circuit, in Clark,rejected the majority view when it held that non-spousal inherited IRAs were not exempt under section 522(b)(3)(C) and (d)(12) of the Bankruptcy Code.[16]  This departure from the mainstream interpretation will prevent debtors in the Seventh Circuit from exempting non-spousal inherited IRAs.  This holding significantly affects debtors who own non-spousal inherited IRAs should be taken into consideration when such debtors decide whether or not to file for bankruptcy.  For example, if a debtor inherits an IRA containing a substantial amount of assets, he may benefit from not filing for bankruptcy and instead using the non-spousal inherited IRA to pay off his debts. At least one court so far has declined to follow Clark,[17] but the Supreme Court will soon settle the rift between the circuits.[18]  In November, the Supreme Court decided to hear Clark.  If the Court decides to side with the Seventh Circuit, then all debtors would be prevented from exempting their inherited IRAs.[19]  During a time period where baby-boomers are leaving IRAs as inheritances, this decision may impact many debtors.[20]

[20] Id.