The U.S. Circuit Court of Appeals for the Seventh Circuit has affirmed a bankruptcy court’s decision that an individual retirement account inherited by a non-spouse beneficiary was not exempt from the beneficiary’s bankruptcy estate (In the matter of Clark, CA-7, 2013-1 ustc ¶50,389). Inherited IRAs do not qualify for the bankruptcy exemption for retirement funds because they are not savings reserved for use after their owners stop working, the Seventh Circuit determined.
The Bankruptcy Code specifically exempts retirement funds from a debtor’s bankruptcy estate to the extent that they are exempt from taxation under the Internal Revenue Code. Under the Tax Code, a spouse who inherits his or her deceased spouse’s IRA can either keep the funds separate or roll them over into his or her own IRA. Either way, the Seventh Circuit noted, the money would remain “retirement funds” in the same sense as before the original owner’s death: the surviving spouse cannot withdraw any of the money before age 59-1/2 without paying a penalty tax, and withdrawals must begin no later than the year in which the survivor reaches 70-1/2.
The Tax Code treats non-spousal inherited IRAs differently. A non-spouse beneficiary can make no new contributions to an IRA he or she inherited. The IRA’s balance cannot be rolled over or merged with any other account. Distributions must begin within a year of the original owner’s death, and the payout must be completed in as little as five years, but some inherited IRAs may be paid out over longer periods.
In light of these differences, the Seventh Circuit determined that a non-spousal inherited IRA is a time-limited tax-deferral vehicle, not a place to hold wealth for use after the new owner’s retirement. An inherited IRA has none of the economic attributes of a retirement vehicle because the money cannot be held in the account until the current owner’s retirement. Further, exempting an inherited IRA from a bankruptcy estate would shelter from creditors a pot of money that could be freely used for current consumption, the court observed.
The Seventh Circuit’s decision creates a split among the courts. The Fifth Circuit, the U.S. Bankruptcy Appellate Panel, Eighth Circuit, and other federal courts have ruled that a non-spousal inherited IRA is exempt from the bankruptcy estate.