Bankruptcy & Insolvency
The Supreme Court held that funds held in an inherited IRA are not retirement funds that are exempt from a bankruptcy estate.
Background
Heidi Heffron-Clark was the sole beneficiary of a traditional IRA account established by her mother. In 2001, her mother died, and the account passed to Heffron-Clark, becoming an inherited IRA. In October 2010, Heffron-Clark and her husband (the Clarks), filed a Chapter 7 bankruptcy petition. They identified the inherited IRA, by then worth roughly $300,000, as exempt from the bankruptcy estate under 11 U.S.C. §522(b)(3)(C), which exempts "retirement funds" held in certain specified tax-exempt accounts from a debtor's bankruptcy estate.
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. The Bankruptcy Court agreed, disallowing the exemption ( In re Clark , 450 B.R. 858 (Bankr. W.D. Wis. 2011)). The court concluded an inherited IRA does not contain retirement funds because, unlike with a traditional IRA, the funds in an inherited IRA are not segregated to meet the needs of, or distributed on the occasion of, any person's retirement.
The district court reversed, explaining that the exemption covers any account containing funds "originally" "accumulated for retirement purposes" ( Clark v. Rameker , 466 B.R. 135 (W.D. Wis. 2012)). The Seventh Circuit reversed the district court's decision ( In re Clark , 714 F.3d 559 (7th Cir. 2013)). Pointing to the different rules that apply to inherited and noninherited IRAs, the Seventh Circuit concluded that "inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings."
The Fifth Circuit, for reasons similar to those of the district court in In re Clark , held in In re Chilton , 674 F.3d 486 (2012), that an inherited IRA is an asset that is exempt from a bankruptcy estate. The Supreme Court agreed to hear the Clarks' case to resolve the conflict between the Seventh Circuit and the Fifth Circuit.
The Supreme Court's Decision
The Supreme Court held that funds in an inherited IRA are not retirement funds under Section 522(b)(C)(3) of the Bankruptcy Code and thus Heffron-Clark's inherited IRA was not exempt from the Clarks' bankruptcy estate. The Court found that retirement funds are funds "set aside for the day an individual stops working" and that three legal characteristics of inherited IRAs indicate that inherited IRAs do not contain retirement funds.
Because the Bankruptcy Code does not define "retirement funds," the court found it should use its ordinary meaning. Looking at a dictionary definition of the words "retirement" and "funds," the Court determined that the ordinary meaning of retirement funds was "sums of money set aside for the day an individual stops working."
The Court then explained that, as the parties agreed, whether funds fell within this definition of retirement funds was an objective question and did not turn on a particular debtor's subjective purpose for the funds. Thus, the Court looked at the legal characteristics of an inherited IRA to decide whether funds in such an account fall within the ordinary meaning of retirement funds.
The Court identified three legal characteristics of an inherited IRA that led it to conclude that funds in an inherited IRA are not objectively set aside for the purpose of retirement. First, unlike holders of traditional and Roth IRAs (which the court called the "quintessential retirement funds") a holder of an inherited IRA cannot invest additional money in the account. Second, holders of inherited IRAs are required to withdraw money from such accounts no matter how many years the holders may be from retirement, whereas traditional and Roth IRA holders do not have to make withdrawals until retirement. Finally, the holder of an inherited IRA, again unlike holders of traditional or Roth IRAs, can withdraw the entire balance in the account at any time for any purpose without incurring a penalty, a feature the Court found indicated that the funds were not funds objectively set aside for one's retirement.
The Court also noted that not treating funds in an inherited IRA as retirement funds was consistent with the purpose of the Bankruptcy Code's exemption provisions, which generally seek to carefully balance the interests of creditors and debtors. The purpose served by the exemption for retirement funds, the Court explained, is to help ensure that debtors will be able to meet their basic needs during retirement. The early withdrawal penalty rules for traditional and Roth IRAs are intended to prevent debtors from enjoying an immediate cash windfall from having these accounts exempted from a bankruptcy estate. On the other hand, the court observed, nothing in the rules for inherited IRAs would prevent a debtor who had such an account exempted from bankruptcy from using the funds in the account for any purpose, including frivolous ones. The Court stated:
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," [citation omitted] into a "free pass." [Slip op. at 7.]
The Court also explained why it rejected the Clarks' various arguments in support of treating the funds as retirement funds. The Clarks' primary argument was that the funds in an inherited IRA, regardless of whether the inherited IRA is a retirement account, are funds that originally qualified as retirement funds by virtue of having been held in a traditional or Roth IRA by the initial owner. According to the Clarks, the death of the initial owner of the funds does not affect their characterization as retirement funds.
The Court disagreed with this interpretation of the statute for two reasons. First, it found that it flew in the face of the ordinary usage of the term "retirement funds." The Court observed that ordinarily "retirement funds" is used to refer to funds that are currently in an account set aside for retirement, not funds that were set aside for that purpose at some prior date by an entirely different person. It also noted that the Clarks' interpretation would mean that any withdrawal from a retirement account would, no matter who it was given to and where it was deposited, retain its characterization as retirement funds, which the Court stated was plainly incorrect.
The Court further found that this interpretation would render a substantial portion of Section 522(b)(3)(C) superfluous. The Court read Section 522(b)(3)(C) as having two conditions for funds to be exempt: (1) that the funds must be "retirement funds" and (2) they must be held in one of the types of covered accounts specified in the statute. The Clarks' interpretation of the statute would eliminate the first condition. Therefore, the Court stated that it "flouted" the rule that a statute should be construed so that all of its provisions are given effect and none will be inoperative or superfluous.
Reflections
The Court's decision reflects what seemingly must have been Congress's intent, although the fact that numerous courts that have confronted the issue have found differently indicates that the statute's language is at best ambiguous. As the Court suggests, exempting inherited IRAs from a debtor's bankruptcy estate would simply give the debtor an undeserved windfall at the expense of creditors. As it would have been for the Clarks, that windfall can be significant.
Clark v. Rameker , No. 13-299 (U.S. 6/12/14)
