During a participant’s lifetime, his or her IRA is considered “retirement funds” that are protected from the participant’s creditors, even if the participant files bankruptcy.   But, what happens to the creditor protection after the participant’s death?  Is the IRA now protected from the beneficiary’s creditors?  Whether post-death creditor protection is available to inherited IRAs under the 2005 Bankruptcy Act has been the subject of a number of cases decided in the last year.

The argument made by bankruptcy trustees is that, on the death of the initial IRA owner, the IRA ceases to be “retirement funds”, as it is not the retirement funds of the beneficiary, and therefore loses the protection afforded to the IRAs under the Bankruptcy Code.

In re Clark, 450 B.R. 858 (Bkrtcy. W.D. WI, May 10, 2011) is the latest in a long line of cases that have been decided in the last year or so under the 2005 Bankruptcy Code.  However, unlike the rulings of the various bankruptcy courts in the previous cases that ruled that the debtor’s inherited IRA was an exempt asset, and therefore protected, the bankruptcy court in Clark ruled that the debtor’s inherited IRA was not exempt in bankruptcy, and therefore not protected.

In Clark, the debtor had inherited the IRA from her mother in 2000 and had been taking required minimum distributions from the inherited IRA since that time.  The debtor filed for bankruptcy in Wisconsin in 2010.  The debtor 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 apply.  The debtor claimed that, based on her arguments, the inherited IRA was an exempt asset, and should therefore retain its protected status.

The Clark court first reviewed all of the cases involving the treatment of inherited IRAs decided prior to the 2005 Bankruptcy Act.  These cases each depended solely on the court’s interpretation of applicable state law.  All but one of these cases held that the inherited IRA was not exempt from the bankruptcy estate of a beneficiary, which caused a number of states to change their laws to specifically provide bankruptcy protection for inherited IRAs.

The Clark court then reviewed all of the cases decided since enactment of § 522(b)(3)(C) of the Bankruptcy Code.

After reviewing all of these cases, the Clark court concluded that none of these cases was controlling on its decision in this case, as each of them dealt with smaller dollar amounts and distinguishable facts.  The Clark court then proceeded to conduct an independent analysis of the issue.

In its analysis, the Clark court applied the same 2 prong test applied in all the other cases, that the inherited IRA (1) must be “retirement funds” and (2) must be in a tax exempt account.  However, the Clark court concluded that to be “retirement funds”, they must have been set aside for the debtor’s retirement.  It was not sufficient that the funds were set aside for “someone’s” retirement.  The court based this on the plain meaning of “retirement” and the differences between a traditional IRA set up for the owner’s retirement and an inherited IRA.  The fact that the inherited IRA was once someone’s retirement account was, in this court’s view, wholly irrelevant.

Having failed one of the requirements under the Federal Bankruptcy Code, this would seem to have been sufficient to support the court’s ruling that the inherited IRA was not exempt in bankruptcy, but the court did not stop there.  Instead, the court developed a rather suspect theory as to why the inherited IRA was not a tax exempt amount.  The court stated that, due to the absence of direct legal authority that the inherited IRA was tax exempt, the court could not “conclude that the debtors’ inherited IRA is governed by IRC § 408 or is tax exempt under that section,” and since each distribution from the inherited IRA is taxable, the account was not tax exempt.

After a long line of cases holding under various states’ laws that an inherited IRA is exempt in bankruptcy, this case bucks the trend and creates further uncertainty as to whether an inherited IRA will be exempt in bankruptcy.  Certainly trustees in bankruptcy will continue to challenge the issue.  To be absolutely sure of the creditor protection for the beneficiary of an inherited IRA, you should talk to your attorney as to whether you should use a spendthrift trust as a beneficiary of your IRA.

It is important to note that if any IRA is included in the debtor’s bankruptcy estate, any distribution in satisfaction of creditors is a taxable distribution that is includible in the income of the debtor.