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On June 12, 2014, the United States Supreme Court ruled in a unanimous opinion that inherited Roth and traditional IRAs are not protected from creditors under the “retirement funds” exemption in the U.S. Bankruptcy Code. The case is Clark v. Rameker, Trustee, 573 U.S. ____ (2014).

In 2001, Heidi Heffron-Clark inherited a traditional IRA worth approximately $450,000 from her mother, Ruth Heffron. Ms. Heffron-Clark elected to take monthly distributions from the account. In 2010, Ms. Heffron-Clark and her husband Brandon Clark filed Chapter 7 bankruptcy and identified the inherited IRA, then worth approximately $300,000, as exempt under Bankruptcy Code Section 522(b)(3)(C). The bankruptcy trustee and unsecured creditors objected to the exemption on the ground that funds in an inherited IRA were not “retirement funds” within the meaning of the statute. The Bankruptcy Court agreed, and disallowed the exemption. The Clarks appealed to the District Court, which reversed the decision of the Bankruptcy Court. Undeterred, the bankruptcy trustee Rameker appealed to the 7^th Circuit Court of Appeals, which reversed the District Court and ruled that the inherited IRA was not exempt. The 7^th Circuit Court expressly disagreed with the 5^th Circuit’s ruling in In Re Chilton, 674 F.3d 486 (2012), which ruled in favor of the debtor’s exemption of an inherited IRA. The U.S. Supreme Court decided to hear the case to resolve the conflict between the Circuit Courts.

When an individual debtor files bankruptcy, his assets become part of the bankruptcy estate. However, the Bankruptcy Code allows debtors to exempt from the bankruptcy estate some limited property. The exemption in this case allows debtors to protect “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code” (see Sections 522(b)(3)(C) for state exemptions and 522(d)(12) for federal exemptions) . Traditional IRAs are created under Internal Revenue Code (IRC) Section 408, and Roth IRAs are created under IRC 408A.

The Supreme Court ruled that the ordinary meaning of “retirement funds” is properly understood to be sums of money set aside for the day an individual stops working. According to Justice Sotomayor, who wrote the unanimous opinion for the Court, there are three legal characteristics of inherited IRAs which provide objective evidence that they do not contain such funds: 1) the holder of an inherited IRA may never contribute additional money to the account; 2) holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement; and 3) the holder of an inherited IRA may withdraw the entire balance of the account at any time, and use the money for any purpose, without penalty. This interpretation is said to be consistent with the purpose of the Bankruptcy Code’s exemption provisions, which effectuate a careful balance between the creditor’s interest in recovering assets and the debtor’s interest in protecting essential needs. Nothing about an inherited IRA’s characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for purposes of current consumption. The court was not persuaded by the Clarks’ claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for that purpose.

So what are the implications of this ruling for those who inherit traditional or Roth IRAs? If the inheritor of an IRA is a spouse who is under age 59 ½, they would normally want to leave the IRA as a beneficiary (inherited) IRA rather than roll the IRA into their own account. As long as the funds are being distributed from an inherited IRA there is no 10% premature distribution penalty, and the spouse would not be required to withdraw money from the IRA until their deceased spouse would have reached age 70 ½. This gives the surviving spouse access to money in the inherited IRA which they may need. However, now an inherited IRA will not be protected in bankruptcy in most cases, so a spouse who is in financial difficulty may decide to roll the inherited IRA into their own IRA where at least it will have creditor protection.

If a non-spouse beneficiary inherits an IRA, it cannot be rolled into their own IRA and must either be distributed entirely by the end of the 5^th year following the year of death or over the inheritor’s expected lifetime. If the IRA is inherited directly by the non-spouse beneficiary, there will be no way in many cases to protect that IRA in bankruptcy. One solution that some planners have proposed is the leave the IRA to a properly drafted spendthrift trust rather than to the beneficiary directly. Having the IRA inherited by a properly drawn spendthrift trust can prevent the IRA funds from going to the beneficiary’s creditors. This ruling may be a boon to estate planning attorneys.

The news is not all bad, however. Some states, such as Texas and Florida, specifically protect inherited IRAs from creditors. Debtors who live in these states will have their inherited IRAs protected from creditors outside of the bankruptcy context and even in bankruptcy (assuming they meet the residency requirements) if they choose to use the state exemptions instead of the federal exemptions. However, a person with a large IRA should not automatically assume that the IRA would be protected even if they and their children live in a state with creditor protection for inherited IRAs. The state exemptions apply to the residence of the debtors, not to the residence of the deceased person, and people move around a lot. Life happens. Where your beneficiaries live now may not be where they live after inheriting your IRA. Unexpected events occur, and you must plan for them.

One thing is certain – estate planning for those with beneficiaries who are struggling with financial issues has become even more important. Also, bankruptcy planning for anyone who has a large inherited IRA just got more complex.

For a more complete analysis of the Clark v. Rameker case see the blog post of Texas bankruptcy attorney Steve Sather at http://stevesathersbankruptcynews.blogspot.com/2014/06/supreme-court-denies-exemption-for.html. You may read the Supreme Court’s opinion at http://www.supremecourt.gov/opinions/13pdf/13-299_mjn0.pdf.

Nothing in this article is intended as tax, legal or investment advice. If you need assistance with estate or bankruptcy planning, you should consult with a competent professional who practices law in these areas.

Your question was:

“I had $104,000. that I rolled in to an account with an IRA custodian – it was invested in a “bad” company called “****” my account shows the money as a loss on statement. As well I purchased two out of state properties that appear on my IRA account- both were sold … but no one ever paid for them- can any of this be written off in taxes, even though it is a “traditional IRA ”

The answer:

You can only deduct losses in a traditional IRA to the extent that you close all of your traditional IRAs and the total received as a distribution is less than the total undistributed after-tax contributions. For example, if you contributed $5,000 in non-deductible contributions and then built it up to $100,000, then you lost it all in a bad investment, all you could deduct when all of your traditional IRAs were closed would be the $5,000 after-tax basis in your account. Your deduction would be reported as a miscellaneous deduction subject to the 2% of adjusted gross income floor, which means that all of your miscellaneous deductions together must exceed 2% of your adjusted gross income before any of it becomes deductible on your Schedule A. This may limit further your ability to deduct your losses.

If all of the money in the IRA was pre-tax money (in other words, you deducted the contributions when you made them or were not taxed on the money contributed from an employer, assuming the money came from a former employer plan that was rolled into the traditional IRA), then you would be able to deduct none of your losses at all. The reason for this is that none of the money in the account was ever taxed in the first place, so therefore you cannot deduct the losses, since to do so would represent a double deduction, once when contributed and again when the money was lost. The following explanation is found on page 42 of IRS Publication 590, which you can download from www.irs.gov:

Recognizing Losses on Traditional Reporting and Withholding

IRA Investments Requirements for Taxable Amounts

If you have a loss on your traditional IRA investment, you can recognize (include) the loss on your income tax return, but only when all the amounts in all your traditional IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your traditional IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions on Schedule A (Form 1040). Any such losses are added back to taxable income for purposes of calculating the alternative minimum tax.

Example. Bill King has made nondeductible contributions to a traditional IRA totaling $2,000, giving him a basis at the end of 2010 of $2,000. By the end of 2011, his IRA earns $400 in interest income. In that year, Bill receives a distribution of $600 ($500 basis + $100 interest), reducing the value of his IRA to $1,800 ($2,000 + $400 – $600) at year’s end. Bill figures the taxable part of the distribution and his remaining basis on Form 8606 (illustrated).

In 2012, Bill’s IRA has a loss of $500. At the end of that year, Bill’s IRA balance is $1,300 ($1,800 – $500). Bill’s remaining basis in his IRA is $1,500 ($2,000 – $500). Bill receives the $1,300 balance remaining in the IRA. He can claim a loss for 2012 of $200 (the $1,500 basis minus the $1,300 distribution of the IRA balance).

The rules for deducting losses in a Roth IRA are similar, except all money contributed to a Roth IRA is, by definition, after-tax money, so the deduction for a Roth IRA loss would be equal to the undistributed contributions to the account, subject to the 2% of adjusted gross income floor as discussed above.

If this seems a bit complicated, unfortunately it is. It is best to get the advice of a competent CPA to help you with this so that it is done right considering your personal tax situation. I am unable to give you tax or legal advice, but hopefully I was able to point you in the right direction.

I’m sorry for your loss and I wish you the best of luck in your future investments.

H. Quincy Long – President

The IRA Web Advisor

Tag Archives: asset protection

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