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Retirement Funds Are Exempt … Except When They’re Not

In Illinois, as in most jurisdictions, retirement funds like 

  • Pension proceeds
  • 401(k) accounts
  • 403(b) accounts
  • IRA’s and Roth IRA’s 

constitute exempt assets that cannot be taken away in Bankruptcy. 

But what if a Debtor were to inherit an IRA? Would the inheritance still be “exempt?”

This was the issue before the Bankruptcy Court for the Western District of Wisconsin in the case of In re Clark. The Clark Court found that the retirement funds did not retain their exempt character. 

The 7th Circuit Court of Appeals agreed; noting that  11 USC 522(b)(3)(C) and (d)(12) only makes an IRA exempt if it is part of a tax exempt fund  Thus a spouse that inherits or rolls over a retirement fund can take advantage of the exemption because they are bound by the same IRS rules that bound the deceased – that money could not be withdrawn (without penalty) until the inheritor reached age 59 1/2. But if the inheriting spouse wanted to take a distribution before then, the transfer or rollover would be retroactively treated as a taxable event.

Rules applicable to a non-spouse inheritor are even more strict, and those differences played a large role in the decision of the 7th Circuit. As noted by the Court for instance, the Debtor in Clark inherited an IRA from her mother since she was the beneficiary. But an inherited IRA cannot be rolled over into another IRA, and additional funds could be be added to the inheritor’s IRA per 26 USC 408(d)(3)(C)); and since all distributions from the inherited IRA would have to commence within a year according to 26 USC 402(c)(11)(A), the Court refused to treat those funds as exempt because doing so would be the equivalent of form over substance.

Unfortunately, resolving this issue isn’t that easy. The 7th Circuit isn’t the only Federal Appeals Court that has considered this issue: and wouldn’t you know it, there’s a circuit split. 

The 5th and 8th Federal Circuits treat inherited retirement funds as exempt. See In re Nessa, 426 BR 312 (BAP 8th Cir. 2010), In re Chilton, 674 F.3d 486 (5th Cir. 2012). The rationale is that 522(b)(3)(C) of the Bankruptcy Code specifies that retirement funds in the Debtor’s possession are exempt.

The 7th Circuit on the other hand examined the nature of the inherited funds following their distribution. Since such funds could not be held until Debtor’s retirement, to simply treat them as retirement funds would exalt form over substance. Put another way, the 7th Circuit believed inherited IRA funds were an “opportunity for current consumption, not a fund for retirement savings.”

Since there is a Circuit split on this issue, it is important to determine which way the wind blows where you are; and if the Debtor has a choice as to where to file, it would be a wise to keep these factors in mind. An interesting issue not addressed by the Clark opinion is this: 

What if the Debtor in that case had actually within a year of retirement (i.e. 59 1/2 years old)? 

In that instance, an inherited IRA could be held until the Debtor’s retirement. Ultimately that is a case for another day. 

But if Clark is the law of the land then another question comes to mind: 

Is there a way around the harsh results of the 7th Circuit’s Clark decision? 

Well, other than filing in the 5th or 8th Circuits, the answer seems to be that in order to avoid such a problem, estates would have to roll their IRA’s into Trusts having a valid discretionary or spendthrift provision. Under those circumstances the money in the Trust would still be exempt from Bankruptcy execution (albeit not because it was in an IRA but because it was in a spendthrift trust).

As usual, no perfect solution, but it pays to plan. Thinking of your estate or planning for the future? Contact us for a free consultation to find out how to deliver more to your heirs and less to Uncle Sam.

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