Will Inherited IRAs Be Used As A Tool for Protecting An Inheritance from Creditors?

A recent decision out of a New Jersey Bankruptcy Court highlights a loophole in the Bankruptcy Code which may allow Chapter 7 debtors to keep significant assets out of the hands of trustees and creditors.

In In re Norris,[1] the Bankruptcy Court considered whether an inherited individual retirement account is property of the bankruptcy estate. Prior to the Debtor filing her bankruptcy case, her stepmother passed away, leaving an inherited IRA naming the Debtor as the beneficiary. In her amended schedules, the Debtor listed the inherited IRA, claiming it as fully exempt under 11 U.S.C. §522(d)(12), but also claiming the inherited IRA was not property of the estate.[2] The Chapter 7 Trustee objected to the exemption and requested the inherited IRA be deemed property of the bankruptcy estate.

The Bankruptcy Court ruled in favor of the Debtor, holding that the inherited IRA was exempt. In reaching its decision, the Bankruptcy Court focused on the threshold question of whether the funds could be deemed property of the estate. While generally, a debtor’s estate is comprised of all legal and equitable interests of the debtor as of the commencement of the case, there are a few exceptions.[3] Section 541(c)(2), otherwise known as the spendthrift trust exception, provides that “a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” The Court cited an applicable New Jersey statute which provides that any property held in a qualifying trust and any distributions from that qualifying trust are exempt from all claims of creditors and are excluded from the estate in bankruptcy.[4] The statute specifically lists trusts created or qualified and maintained under Section 408 of the Internal Revenue Code, which includes IRAs.

Following the Third Circuit’s analysis in In re Yuhas, 104 F.3d 612 (3d Cir. 1997), the Bankruptcy Court applied a five part test to determine whether an IRA is excluded from the bankruptcy estate under Section 541(c)(2) of the Code:

1. The IRA must constitute a “trust” within the meaning of Section 541(c)(2);
2. The funds must represent debtor’s “beneficial interest” in that trust;
3. The IRA must be qualified under Section 408 of the Internal Revenue Code[5];
4. The provision of N.J.S.A. stating that property held is exempt from all claims of creditors must be a restriction on the transfer of the IRA funds; and
5. The restriction must be enforceable under nonbankruptcy law.

With four of these elements easily satisfied, the ultimate question for the Bankruptcy Court was whether the change from an IRA to an inherited IRA also changes the asset’s “qualifying status” under the applicable New Jersey statute. While there are distinctions between IRAs and inherited IRAs regarding disposition of funds and tax treatment, the Bankruptcy Court nevertheless found that the six requirements of a qualified trust set forth in 28 U.S.C. §408(a)(1)-(6) were satisfied by the IRA agreement with Mutual of America.

In reaching its decision that the inherited IRA was not property of the estate, the Bankruptcy Court ultimately declined to consider the Debtor’s argument that the inherited IRA was exempt. In this way, the Court deemed the Supreme Court’s decision in Clark v. Rameker,[6] inapplicable on the grounds that the Supreme Court considered only whether an inherited IRA could be considered “retirement funds” for the purpose of the retirement exemption in Section 522(b)(3)(c).

Nonetheless, the Bankruptcy Court did acknowledge that key distinctions between IRAs and inherited IRAs raise significant concerns noted by the Supreme Court in Clark v. Rameker –the debtor beneficiary of an inherited IRA may withdraw the entirety of the funds at any time and for any purpose, and in fact, must withdraw the entirety of the funds within five years or take a minimum annual distribution every year. With no restrictions on distributions from the inherited IRA, the door is left open for future abuse: potentially significant assets can be excluded from a bankruptcy estate, while the debtor is free to use those inherited funds whenever and however he or she sees fit.

[1] In re Norris, Case No. 15-26458, Docket No. 31 (Bankr. D.N.J. Memorandum Opinion dated May 20, 2016).

[2] Id. at p. 2 (citing In re Yuhas, 104 F.3d 612 (3d Cir. 1997); In re Andolino, 525 B.R. 588 (Bankr. D.N.J. 2015)).

[3] 11 U.S.C. §541(a).

[4] In re Norris, Memorandum Opinion at 4-5 (citing N.J.S.A. 25:2-1(b)).

[5] 26 U.S.C. §408(a).

[6] 134 S. Ct. 2242, 2247 (2014).

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