Lawyer Ron Roteman recently met with a client who wanted to have about $400,000 in debts wiped clean by declaring a Chapter 7 bankruptcy, but after scanning the client’s balance sheet, Roteman knew right away he was better off not filing.
The client had just inherited an individual retirement account from his deceased mother worth about $75,000, and the U.S. Supreme Court ruled in 2014 that anyone seeking bankruptcy protection must forfeit all money from an inherited IRA to creditors to settle debts.
“We had the choice of either giving up the money to creditors or allowing him to spend it,” said Roteman, a partner at Stonecipher law firm who specializes in consumer and business bankruptcies. “(My client) would not have been able to protect his inherited IRA. We needed to formulate a strategy to deal with this particular asset prior to filing bankruptcy.”
Since the enactment of the federal Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, individual retirement accounts and 401(k) accounts have been protected under federal law if the owner of the account declares bankruptcy. The exemption was originally capped at $1 million, but has since grown to about $1.2 million — as of April 2014 — due to cost of living increases.
But federal courts for years been divided over whether of not inherited IRAs are entitled to the same protection under the act.
The Supreme Court resolved the issue when it agreed to hear the case of Clark v. Rameker. The High Court decided that under federal law inherited IRAs do not fall under the category of protected retirement funds.
The court’s rationale was that the holder of an inherited IRA cannot invest new money into the account; can withdraw the entire balance at any time and use the funds for any reason without penalty; and must take required distributions from the account no matter how far the holder is from retirement.
The court ruling also means inherited 401(k)s are not protected, unless the account is inherited by a surviving spouse.
There is no dollar amount limit on 401(k) account balances. The $1.2 million cap on IRAs owned by bankruptcy filers does not apply to amounts rolled over from a qualified employer plan such as a 401(k). The full amount of a participant-owned 401(k) is fully protected under federal law.
Inherited IRAs and 401(k)s are likely to become more relevant in the coming years as more parents from the World War II generation — the wealthiest batch of seniors in U.S. history — prepare for the transfer to their baby boomer children and grandchildren.
According to a 2014 report by researchers at the Center on Wealth and Philanthropy at Boston College, an estimated $59 trillion — divided among heirs, charities, estate taxes and estate closing costs — will be transferred from 93.6 million estates from 2007 to 2061 in the greatest wealth transfer in U.S. history.
There are some circumstances where an inherited IRA may be protected to some extent.
Individual states are allowed to establish their own bankruptcy exemptions. States that exempt all inherited individual retirement accounts include Arizona, Alaska, North Carolina, Missouri, Florida, Texas and Ohio.
Also, spouses who inherit an IRA from a deceased spouse as sole beneficiary are generally entitled in all states to treat that IRA as their own, which means it would be exempt from creditors in a bankruptcy filing.
Tara Twomey, a board member of the Washington-based National Association of Consumer Bankruptcy Attorneys, said the organization participated in the Supreme Court case as a third party arguing that inherited IRAs should be exempt from creditors.
“We believe bankrupt filers should be able to keep inherited IRAs, but we were on the losing side,” Twomey said. “Inherited IRAs are treated like any other asset that comes to the bankruptcy table,” in all states that do not provide protection from creditors.
“People who have inherited an IRA and need to file bankruptcy will now have to consider the decision to file bankruptcy. In many cases, it may tip the scale against filing,” she said. “Anytime you have a situation where the debtor cannot get their fresh start, which is the goal of bankruptcy, it makes it more difficult to recover from financial stress and move forward again.”