The bankruptcy code generally exempts certain retirement funds from creditors. When someone inherits a retirement account as the beneficiary, is the account still a retirement asset or is it something else? This issue has been debated back and forth in court for several years to the point where the U.S. Supreme Court finally needed to resolve the issue. In July 2014, the court decided in Clark v. Rameker that funds held in inherited IRAs aren’t “retirement funds” under the Bankruptcy Code and are, therefore, not an exempted asset in bankruptcy.
It may surprise some that the court ruled inherited retirement accounts are not retirement funds. However, it makes sense when you consider why retirement accounts are protected. The government encourages retirement savings by allowing taxpayers to make qualified contributions to retirement accounts on a tax-deferred basis. The tax code is written to ensure that retirement accounts are not used as ordinary savings by penalizing withdrawals from the account until the account owner reaches age 59½. For this reason, the funds held in the account are not accessible and are protected from creditors.
In the case of an inherited IRA, the designated beneficiary can access the funds without penalty. One of the penalty exemptions is death of the account holder. The beneficiary is actually required to withdraw funds from the retirement account and must choose to either: (1) withdraw the entire balance within 5 years of the original account holder’s death, or (2) take minimum distributions until the fund is depleted. In fact, the beneficiary of an inherited IRA isn’t permitted to make contributions to the account, they may only take withdrawals.
Other than income tax due on distributions from the retirement account, there’s little difference between an inherited retirement account and cash. The penalties for early withdrawal from retirement accounts help ensure a debtor won’t cash them out and use the funds like cash immediately after being discharged from bankruptcy. Inherited retirement accounts offer no such assurance. The Supreme Court believed that excluding inherited retirement accounts would provide a free pass for debtors, and ruled to remove that exemption.