U.S. Court of Appeals Reverses Ruling in Bankruptcy Case Involving Inherited IRA Funds

U.S. Court of Appeals Reverses Ruling in Bankruptcy Case Involving Inherited IRA Funds
On April 23, 2013, the U.S. Court of Appeals for the 7th Circuit reversed a District Court ruling and reinstated a determination by a bankruptcy court that inherited IRA funds were no longer “retirement funds” and thereby exempt or protected from creditors in a bankruptcy proceeding.

Generally, IRA’s are either exempt from claims of creditors in bankruptcy, or in New Jersey, are completely disregarded as “property of the bankruptcy estate”. This decision shows that inherited IRA’s (called IRA-BDA accounts) are a different animal. How they are treated and whether they can be seized by a bankruptcy trustee to pay creditors can be a critical issue.

The Facts

Heidi Heffron-Clark’s mother, Ruth Heffron, owned, at the time of her death, an individual retirement account worth approximately $300,000. Her IRA went Heffron-Clark. According to tax laws, the IRA remains a tax-sheltered investment, but with limitations. There can be no new contributions to the IRA and it cannot be rolled over into any other account. In addition, federal law requires that “minimum required distributions” take place from the IRA starting no later than one year after the death of the original owner (Ruth Heffron).

After receiving the inherited IRA, Heffron-Clark and her husband filed for bankruptcy protection. In that petition, they claimed that the IRA funds were exempt from the reach of the bankruptcy courts as “retirement funds.” The bankruptcy court judge disagreed, concluding that the funds were never held as “retirement funds” by Heffron-Clark and by law must be distributed. Heffron-Clark appealed to the District Court, which reversed the bankruptcy court ruling, citing a prior opinion that held that “retirement funds” in a decedent’s hands must also be treated as “retirement funds in the hands of a beneficiary.”

The Court of Appeals overturned the District Court ruling, stating that upon the death of an IRA’s owner, those funds are no longer anyone’s “retirement funds.” To hold otherwise, the court concluded, would be to allow a debtor free access to a substantial pot of money never intended for their retirement. The court held that inherited funds in the form of an IRA are still inherited funds and are not a form of retirement funds under bankruptcy law.

This issue is one likely to end up before the Supreme Court if Congress does not address it. Right now there is a disagreement between the Circuit Courts of Appeal that have addressed this issue. Stay tuned.

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