A Wisconsin Couple . . . An Individual Retirement Account . . . A Bankruptcy Trustee . . . A Supreme Court Decision

The Supreme Court decision in Clark v. Rameker has been in the can for a few months now, and folks have been clamoring for us to parse it. Well, OK, clamor is a tad strong, but here we go:

The Backstory:

Everyone knows that the U.S. Bankruptcy Code provides a forum to bring order to situations where an individual’s debts and obligations exceed his assets and his ability to pay creditors. Once that debtor’s assets are liquidated by the bankruptcy trustee and the funds are distributed to the creditors, the debtor is “discharged” – i.e., legally free from having to pay his or her formal debts. The bankruptcy process also determines which assets should be exempt from liquidation to satisfy a person’s debts. These bankruptcy exemptions recognize that liquidating all of a debtor’s assets may leave the debtor completely destitute and likely dependent on assistance from the State and its taxpayers.

These bankruptcy exemptions vary from state to state, but typically include a personal residence (homestead), retirement accounts, a Bible, clothing, and so on. Some states exempt the entire personal residence regardless of its value (FL; TX; OK); others exempt only certain amounts (IL - $15,000; WI - $75,000; IN - $17,600). The interplay between federal bankruptcy law and the patchwork of state exemption laws is both curious and unpredictable (and is reprised below).

In general though, all retirement accounts that are exempt from income tax until the funds are withdrawn, have also been exempt under the Bankruptcy Code and, therefore, not available to satisfy the claims of creditors. As a result, sometimes pre-bankruptcy planning has involved transferring as much money into retirement plans as possible before filing.

What Happened: Heidi Heffron-Clark inherited a $450,000 individual retirement account (IRA) from her mother in 2001. Sometime later Heidi and her husband were sued in their home state of Wisconsin, and a significant judgment was entered against them. They filed for bankruptcy in 2010 in order to discharge that debt. They claimed the IRA that Heidi inherited (now watered down to about $300,000) was exempt from their creditors’ claims; not unsurprisingly, the bankruptcy trustee disagreed.

The judge ruled that in order to qualify as an exempt retirement fund under the Bankruptcy Code, the retirement funds must be held for the current owner’s retirement. Because the Clarks were required to withdraw money from the inherited IRA before their own retirement, the judge held that the account was not exempt, and was subject to creditor claims in the bankruptcy proceeding. Because of the importance of this issue (and because courts were coming to different conclusions about the “right” answer to this issue around the country), the case was appealed to the district court, then bounced up to the Court of Appeals, and finally kicked on up to the Supreme Court.

The Court Decision:

In a unanimous decision, the United States Supreme Court held that inherited IRAs are not “retirement funds” within the meaning of the Bankruptcy Code, and are available to satisfy creditors’ claims.

The Supreme Court looked to federal tax law for support in its decision. The IRS has developed some special rules for IRAs that are inherited by someone other than the spouse of the deceased – sometimes called “inherited IRA” – that are different from the rules governing IRAs that individuals set up for themselves. For example, these special rules prohibit additional contributions to the inherited IRA, and they require the beneficiary to withdraw, and pay taxes on, a minimum amount from the inherited account each year.

The Supreme Court considered three important factors that distinguish an inherited IRA from an IRA owned by the plan participant:

  • The beneficiary of an inherited IRA cannot make additional contributions to the account, while an IRA owner can.
  • The beneficiary of an inherited IRA must take required minimum distributions from the account regardless of how far away the beneficiary is from actually retiring, while an IRA owner can defer distributions at least until age 70 ½.
  • The beneficiary of an inherited IRA can withdraw all of the funds at any time, and for any purpose, without a penalty, while an IRA owner must generally wait until age 59 ½ to take penalty-free distributions.

The Court observed that the money in an inherited IRA was set aside for the original owner’s retirement and not for the designated beneficiary’s retirement. Ergo: assets in an inherited IRA are reachable by the beneficiary’s creditors.

The Fallout:

This decision caused some heartburn in the estate planning and asset protection universe because its rationale seems also to apply directly to all inherited defined contribution retirement plan accounts -- such as inherited 401(k) and 403(b) accounts. As a result, the planning community has been scrambling to embrace strategies that could be used to avoid the impact of Clark.

One strategy that has been around for a long time has pushed ahead to the front of the line – a stand-alone trust that acts as the beneficiary of the IRA. Let’s see how that strategy plays out under three different spotlights:

A. Protecting Inherited IRAs From Creditors of the Beneficiary. Many of our clients embrace asset protection as an integral part of their estate and financial planning. For that group of clients -- and for anyone who wants to insure that their retirement funds will remain protected for their beneficiaries after death -- Clark mandates reconsideration of any outright beneficiary designation for retirement accounts.

The preferred option for protecting an inherited IRA is to create a separate trust for the benefit of each of the intended IRA beneficiaries. This type of trust can present many planning possibilities:

  • It can protect the inherited IRA from the beneficiary’s creditors.
  • It can insure that the inherited IRA remains in the family and will not benefit the beneficiary’s spouse or unintended others.
  • It can provide for experienced investment management of the assets in the IRA by a professional trustee.
  • It can protect the beneficiary from his or her own imprudent behavior or profligate ways (gambling; substance abuse; etc.).
  • It can assist with planning for a beneficiary with “special needs.”
  • It can enable minor beneficiaries, such as grandchildren, to enjoy an inherited IRA without the need for a court-supervised guardianship.

There are some drawbacks to using the trust as the recipient of the inherited IRA. In this structure, the distributions go from the IRA to the trust; the trust may or may not distribute the funds to the beneficiary. If the funds are distributed to the beneficiary, the beneficiary pays the necessary income tax bill. If it is not distributed to the beneficiary, income tax must be paid by the trust itself. Because trusts have compressed tax brackets (in which the top tax rate of 39.6% kicks in at $12,150 of income in 2014), income that is not distributed from the trust might incur a slightly higher amount of income tax. Furthermore, these trusts also have ongoing accounting and trustee fees that outright distributions do not.

In most cases a conventional revocable trust agreement will not be well-suited to be named as the beneficiary of an IRA. This is because the trust that receives the inherited IRA must be carefully designed to be a “see-through trust.” The see-through trust language can, of course, be incorporated into a typical revocable trust with proper drafting.

B. Clark and IRAs Inherited by a Spouse. The Clark decision considered an IRA inherited by Heidi from her mother. Many commentators have pondered whether Clark might have seen a different result if the IRA was inherited by the spouse of the owner. In general, when a spouse inherits an IRA, he or she has three options, and these are the likely results of those choices under Clark:

  1. The spouse can cash out the inherited IRA and pay the required income tax. If the spouse elects to do this, obviously the IRA will have no creditor protection since the proceeds will become comingled with the spouse’s own assets.
  2. The spouse can maintain the IRA as an inherited IRA. Applying the Clark rationale, the inherited IRA will not be protected from the spouse’s creditors since the spouse is prohibited from making additional contributions to the account, may be required to take distributions prior to reaching age 70 ½, and can withdraw all of it at any time without a penalty.
  3. The spouse can roll over the inherited IRA into his or her own IRA (after which it will be treated as the spouse’s own IRA). Despite the rollover, it is clear that the inherited funds were certainly not set aside by the spouse for his or her own retirement before the rollover was initiated, so a Clark-like result should be expected. In addition, one can anticipate that a creditor, armed with the Clark decision, might challenge the rollover of an inherited IRA into the spouse’s own IRA as a fraudulent transfer under applicable state law.

Again, using a retirement account trust for the benefit of a spouse can address these issues, and others -- such as planning for a second marriage with a blended family. In addition, when coupled with disclaimer planning, a spouse who eventually needs nursing home care may be positioned to more readily be able to qualify for Medicaid.

C. The Effect of State Exemptions. Since the Clark decision, a handful of States (AZ, FL, ID, OH for example) have taken action to protect inherited IRAs in bankruptcy by extending protection to them under the State’s bankruptcy exemptions. If the IRA beneficiary is fortunate enough to live in one of these states (but unfortunate enough to be contemplating bankruptcy), then that beneficiary may very well be able to protect their inherited retirement funds in the bankruptcy environment.

Reliance on the state exemption though, may be problematic as a mobile populace moves from state to state for employment, education, or family reasons. In addition, the Bankruptcy Code now requires a debtor to reside in a state for at least 730 days prior to filing a petition for bankruptcy in order to take advantage of the state’s bankruptcy exemptions. This is designed to eliminate most instances of “forum shopping” when it comes to bankruptcy filing. A retirement account trust as described in this piece is not sensitive to changes in the beneficiary’s geography.

Given the amount of money that will pass to the next generation from retirement accounts, clients need to focus more attention on who -- or what -- to name as the beneficiary of these assets. Clark v. Rameker has underscored the need to review the pros and cons of all beneficiary choices for retirement assets.


Nothing contained in this article should be taken as legal advice for your specific situation. Consultation with competent counsel prior to implementing any legal strategy is highly recommended.

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