The bankruptcy code states that a debtor may exempt amounts that are (1) “retirement funds,” and (2) exempt from income tax under one of several specified internal revenue code provisions.
In Clark, a woman inherited her deceased mother’s IRA as the sole beneficiary. The IRA was worth $450,000, and the woman chose to take monthly distributions from it. The woman, Mrs. Clark, filed a bankruptcy petition under Chapter 7 of the bankruptcy code. Specifically, Mrs. Clark hoped to exempt the inherited IRA.
Creditors, however, objected to the exemption, arguing that the funds held in the inherited IRA were not “retirement funds” within the meaning of the bankruptcy code, and therefore, could not be exempted from the bankruptcy estate. Ultimately, the issue came before the Supreme Court.
The court decided that funds held in inherited IRAs are not “retirement funds.” The court held that “retirement funds” describes money that is set aside for the time that a person is no longer working, and this determination should be based on the legal characteristics of the account holding the funds and whether the account is one that was set aside for when an individual is no longer working.
- The court held that there are three legal characteristics of an inherited IRA that made funds in them not for the purpose of retirement:
- Inherited IRAs prohibit contributions to the account; An inherited IRA requires that the accounts be depleted over time, which is not a feature of an account set aside for retirement; and
- Inherited IRA owners may make penalty-free withdrawals from the account at any time, but traditional or Roth IRA accounts are subject to an early withdrawal penalty.
How might one avoid the result that Mrs. Clark endured? Set up a trust for beneficiaries. The IRA owner could name specific trust beneficiaries. Also, a spousal beneficiary of a decedent’s IRA has the option of treating the IRA as his or her own, rather than being subject to the general rules of “inherited IRAs.” In this arrangement, the surviving beneficiary spouse, as an IRA owner, may defer the start of lifetime IRA distributions to his or her required beginning date.
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