Play It Again Sam–Are Inherited IRAs Protected from Creditors in Bankruptcy?

When the Fifth Circuit, in a case of first impression for that circuit and all of its sister circuit, last year ruled in In re Chilton, 11-40377, 2012 WL 762924 (5th Cir. Mar. 12, 2012) that inherited IRAs constituted retirement funds within the “plain meaning” of §522 of the Bankruptcy Code and were thus exempt from the bankruptcy estate, under § 522(d)(12) (the federal exemptions), many thought the issue was settled. This was especially so because the Fifth Circuit ruling was the last (or so we all thought) in a long line of cases that ruled the same way after the enactment of the 2005 Bankruptcy Act. The Seventh Circuit in Rameker v. Clark, Nos. 12-1241 & 12-1255, United States Court of Appeals (7th Cir. 2013), on April 23, 2013, however, disagreed with the Fifth Circuit and agreed with the argument made by bankruptcy trustees in this case, and in numerous other cases, that on the death of the IRA owner, even though the inherited IRA was still exempt from immediate taxation, the inherited IRA ceases to be “retirement funds” and does not represent retirement funds in the hands of the beneficiary. Consequently, the inherited IRA ceased to have the protection afforded to IRAs under § 522(b)(3)(C) and (d)(12) of the Bankruptcy Code. For a summary of prior cases, see our post from last year: “Are Inherited IRAs Protected in Bankruptcy?”

In Clark, the debtor, Heidi Heffron-Clark, had inherited the IRA worth approximately $300,000 from her mother, Ruth Heffron, in 2000 and Heidi had been taking required minimum distributions from the inherited IRA since that time. Heidi and her husband filed bankruptcy in Wisconsin in 2010. Wisconsin is not an opt out state, permitting debtors to elect to use either the Wisconsin exemptions or the Federal exemptions. Heidi elected to use Wisconsin exemptions and claimed that the inherited IRA was an exempt asset under the Wisconsin exemptions and under 11 U.S.C. § 522(b)(3)(C), the Federal exemption applicable when state exemptions are applicable.

The Seventh Circuit recognized that the term “retirement funds”, although used in § 522(b)(3)(C) and (d)(12) of the Bankruptcy Code for state exemptions and Federal exemptions respectively, was not defined in the Bankruptcy Code. The Court then noted that there are different rules that apply to inherited IRAs than apply to IRAs that are intended as retirement funds, in that no new contributions can be made to an inherited IRA, the funds in an inherited IRA cannot be commingled with any other IRA, and the beneficiary of an inherited IRA is required to start taking minimum distribution in the year following the death of the original owner. Thus, the Court reasoned that “an inherited IRA is a time-limited tax-deferral vehicle, but not a place to hold wealth for use after the new owner’s retirement.”

The Court specifically agreed with the treatment given the inherited IRA by the Bankruptcy Court (In re Clark, 450 B.R. 858 (Bankr. W.D. Wis. 2011)) that the funds in an IRA are only “retirement funds” within the meaning of the Bankruptcy Code if the funds are held for the owner’s retirement, and specifically disagreed with the Fifth Circuit decision of In re Chilton, 674 F. 3d 486 (5th Cir. 2012) and the Eighth Circuit sitting in bankruptcy in In re Nessa, 426 B.R. 312 (BAP 8th Cir. 2010), which the U.S. District Court in Clark v. Rameker, 11-CV-482-BBC, 2012 WL 233990 (W.D. Wis. Jan. 5, 2012) had followed.

The Seventh Circuit stated that Heidi’s inherited IRA did not contain “anyone’s retirement funds.” The Bankruptcy Code should not be used to exempt from creditors’ reach funds that were freely accessible for current use by the debtor, without penalty. The Court recognized that there was reference to the “debtor’s interest” in other exemptions created under § 522 and there was no reference to the debtor in connection with the exemptions in § 522(b)(3)(C) and (d)(12), a point that was important to the Chilton Court and to the Nessa Court. However, the Seventh Circuit in this case saw no reason in the Bankruptcy Code to exempt an inherited IRA from creditors based on the use or purpose that the predecessor owner had for the funds when she saved the funds for her retirement.

While this was not an en banc decision of the Seventh Circuit, in order to give authority to this opinion and its specific challenge to the Chilton Fifth Circuit Opinion, the Court stated that they had circulated the opinion among all of the Seventh Circuit active judges and that none of them had requested an en banc hearing. We will now see whether the Supreme Court picks this up to resolve the split in the Circuits. In any event, it is once again unclear, except in the few states with specific legislation exempting inherited IRAs from creditors’ reach in bankruptcy, whether an inherited IRA is or is not an exempt asset in a bankruptcy proceeding under § 522(b)(3)(C) and (d)(12).