Supreme Court Decisions on Inherited IRAs May Change Calculus on Structuring Beneficiary Designations

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By Deborah M. Beers, Esq.

Buchanan Ingersoll & Rooney, Washington, DC


In Clark v. Rameker,1 the U.S. Supreme
Court, in a unanimous decision, held that inherited IRAs are not
exempt from the beneficiary's creditors because inherited IRAs are
not "retirement funds" within the meaning of 11 USC §522(b)(3)(C)
of the federal Bankruptcy Code. As a result, the creditors of the
beneficiary of an inherited IRA may attach the inherited IRA.

The petitioner in the case, Heidi Heffron-Clark, became the sole
beneficiary of an inherited IRA when her mother died in 2001. In
October 2010, Ms. Heffron-Clark and her husband filed a Chapter 7
bankruptcy petition. They identified the inherited IRA, by then
worth roughly $300,000, as exempt from the bankruptcy estate under
§522(b)(3)(C). The bankruptcy trustee and unsecured creditors of
the estate objected to the claimed exemption on the ground that the
funds in the inherited IRA were not "retirement funds" within the
meaning of the statute, a contention ultimately upheld by the
Supreme Court.

The decision resolves a conflict between the Seventh Circuit's
ruling in Clark, and the Fifth Circuit's decision in
In re Chilton.2


The Bankruptcy Code allows debtors to exempt from the bankruptcy
estate interests in certain kinds of property, including
"retirement funds to the extent those funds are in a fund or
account that is exempt from taxation under section 401, 403, 408
(traditional IRAs), 408A ("Roth" IRAs), 414, 457, or 501(a) of the
Internal Revenue Code." State law also plays a part in that, under
11 USC §522, debtors may elect to claim exemptions either under
federal law, or state law. Both tracks permit debtors to exempt
"retirement funds."

Traditional and Roth IRAs "offer tax advantages to encourage
individuals to save for retirement." Contributions to these types
of IRAs are tax deductible (in the case of traditional IRAs) and
distributions from Roth IRAs are tax free (although contributions
are not tax deductible). To ensure that both types of IRAs are
actually used for retirement purposes and not as "general
tax-advantaged savings vehicles," Congress made certain withdrawals
from both of 59 1/2.3

In contrast, an inherited IRA is a traditional or Roth IRA that
has been inherited after its owner's death. When anyone other than
the owner's spouse inherits the IRA, he or she may not roll over
the funds; the only option (absent certain permissible
trustee-to-trustee transfers or Roth conversions) is to hold the
IRA as an inherited account.

According to the Court, inherited IRAs differ from traditional
IRAs in three important respects:

  • The owner may withdraw funds from an inherited IRA at any time
    (including before age 59 1/2), without paying a tax penalty;
  • The owner of an inherited IRA may never make contributions to the
    account; and
  • The owner of an inherited IRA must immediately begin withdrawing
    funds from the account, regardless of age.4

In addition, in the view of the Court, "the text and purpose of
the Bankruptcy Code make clear that funds held in inherited IRAs
are not `retirement funds' within the meaning of [the] bankruptcy
exemption," because they are not, in the ordinary meaning of those
words, "sums of money set aside for the day an individual stops

With respect to the purpose of the Bankruptcy Code, the Court
noted that the intent of the exemptions is to protect the debtor's
"essential needs," so that he or she "will not be left destitute
and a public charge."5 The legal
limitations on traditional and Roth IRAs ensure that debtors who
hold such accounts (but who have not yet reached retirement age) do
not enjoy a cash windfall by virtue of the exemption-such debtors
are instead required to wait until age 59 1/2 before they may
withdraw the funds penalty-free.

However:… [N]nothing about the inherited IRA's legal
characteristics would prevent (or even discourage) the individual
from using the entire balance of the account on a vacation home or
sports car immediately after her bankruptcy proceedings are
complete. Allowing that kind of exemption would convert the
Bankruptcy Code's purposes of preserving debtors' ability to meet
their basic needs and ensuring that they have a `fresh start,' …
into a `free pass' ….6

Inherited IRAs in effect provide opportunities for current
consumption, as opposed to retirement savings.

Ms. Heffron-Clark also argued that the funds in question, having
once been "retirement funds," should retain that character even
though they now resided in an inherited IRA, and that "[t]he
[initial] owner's death does not in any way affect the funds in the
account." The Court, however, rejected this argument, noting that,
brought to its logical conclusion, the funds in a retirement
account could be entirely withdrawn and invested in a totally
unrelated checking account so long as they could be traced to the
original owner. "That [stated the Court] is plainly incorrect."

Note: First, the Supreme Court's decision
applies only to bankruptcy under the federal Bankruptcy Code. Some
states expressly exempt inherited IRAs under state bankruptcy
statutes (although most currently do not), and it may be possible
to shield inherited IRAs under those statutes. However, reliance on
state statutes can be dangerous if one intends to move, or if
domicile is in any way unclear.

Second, is unclear whether the Court's holding applies to
inherited IRAs of a surviving spouse, although there is no apparent
reason why it should not. A surviving spouse who is the designated
beneficiary of an IRA generally has the option to "roll over" that
IRA into an IRA of his/her own (subject to the penalties for early,
withdrawal, etc.), or to continue as the beneficiary of the
deceased spouse's IRA. This ruling may make that latter option
(often employed where immediate access to the IRA funds is desired
by a younger spouse) less attractive in cases where there are
creditor concerns.

Planning Considerations.

Individuals commonly are the "designated beneficiaries" of
retirement plan accounts, and individual designated beneficiaries
may take distributions over their individual life expectancies,
thus stretching out the payments and prolonging the income tax
deferral.  Certain types of trusts (called "see-through"
trusts) also may be designated beneficiaries.7

Under applicable Reg. § 1.401(a)(9)-4, Q&A-5, the
beneficiaries of a see-through trust may be treated as designated
beneficiaries if the following requirements are met:

  • The trust must be valid under state law;
  • The trust must become irrevocable upon the death of the
  • The beneficiaries of the trust must be identifiable from the trust
  • The trust beneficiaries must be individuals; and
  • The trust indenture and other required documentation must be timely
    provided to the plan administrator.

In general, under the regulations, the life expectancy of the
oldest beneficiary of a see-through trust will be used to calculate
the minimum required distributions (MRDs) from an IRA. If the trust
is not a see-through trust, the account must be distributed over
the participant's life expectancy.

Since see-through trusts may be spendthrift trusts, an inherited
IRA that is held by such a trust may be protected from the claims
of creditors by reason of the trust's terms and state law.

See-through trusts may take many forms (they may, for example,
be subtrusts of a primary trust), but come in two basic iterations:
conduit trusts and accumulation trusts.

Conduit Trusts.  A conduit trust
requires that the trustee pay the MRD received by the trustee from
the inherited IRA directly to one or more individual
beneficiaries.  No plan distributions can be accumulated in
the trust while any individual member of the conduit beneficiary
group is living. If a see-through trust is a conduit trust, then
only the life expectancy of the individual beneficiary (and no
contingent beneficiary) is taken into account in establishing the
distribution period. While this is an advantage, a creditor, while
not able to reach the inherited IRA itself, could attach
distributions as they are received.

Accumulation Trusts . An accumulation
trust, in contrast, is a trust in which the trustee has the power
to accumulate IRA distributions in the trust. Thus, while the
trustee must withdraw from the account the MRD each year, the
trustee need not distribute that amount directly to the beneficiary
of the trust. Such trusts, in QTIP form, may be used to preserve
assets for the participant's children (the remaindermen), while
providing for the distribution of income only (assuming that such
income - of the trust and the IRA - is less than the MRD) to the
spouse of a second marriage. Alternatively, they may take the form
of "discretionary" trusts for children or other descendants. In an
accumulation trust, however, all current and potential
beneficiaries must be counted in determining who is the oldest
beneficiary for purposes of calculating the distribution period.
The rules applicable to determine the class of potential
beneficiaries are complex and may require equally complex drafting
to avoid pitfalls. A creditor nevertheless should not be able to
reach an interest in an accumulation trust to which the individual
beneficiary is not entitled.

Thus, the use of spendthrift accumulation trusts may preserve
the assets of an inherited IRA where the Bankruptcy Code does

For more information, in the Tax Management Portfolios, see
Kennedy, 367 T.M.
, IRAs, Bosley and Hutzelman, 370
, Qualified Plans - Taxation of Distributions,
Mezzullo, 814 T.M., Estate and Gift Tax Issues of
Employment Benefit Plans, Rothschild and Rubin, 810 T.M.,
Asset Protection, and in Tax Practice Series, see ¶6350, Estate
Planning, ¶5610, IRAs, ¶5550, Tax Aspects of Qualified Retirement

  1 No. 13-299, 2014 BL 162980 (U.S. June 12, 2014),
aff'g sub nom. In re Clark, 714 F.3d 559 (7th Cir.

  2 674 F.3d 486 (5th Cir. 2012).

  3 See §72(t)(1)-§72(t)(2).

  4 However, the owner of an inherited IRA must
either withdraw the entire balance in the account within five years
of the original owner's death - if the owner died prior to his/her
required beginning date - or take minimum distributions on an
annual basis. See §408(a)(6), §401(a)(9)(B); Reg.
§1.408-8, Q-1 and A-1(a), incorporating Reg. §1.401(a)(9)-3, Q-1
and A-1(a).

  5 Citing H.R. Rep. No. 95-595, p. 126 (1977).

  6 Clark v. Rameker, No. 13-299, 2014 BL
162980 (U.S. June 12, 2014).

  If there is no designated beneficiary, payments
must be received by the beneficiary over a shorter period of time -
either five years or the deceased participant's life expectancy -
depending on whether the participant had reached his or her
required beginning date.

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