Inherited IRAs and Bankruptcy, what is THE LAW?

  • by

The other day I was talking with a friend, and they told me they were a bit irritated at their CPA.  It seems my friend asked the CPA a “basic” tax question and the CPA said they were going to have to research the subject and of course charge my friend for the research.

My friend was upset because he felt the CPA knew, or should, know the law and was just gouging him.

In fact this is a complaint I get all the time from people who expect me to know every aspect of the tax code.  What people don’t realize is that in many cases there are exceptions to the exceptions as well as contradictory cases and laws.

Lets use the creditor protected status of inherited IRAs as an example.   Courts all across the country have come to opposite conclusions about the exempt status of inherited IRAs in bankruptcy.  Some courts say inherited IRAs are exempt from the claims of creditors, other courts say inherited IRAs are not protected assets.

Lets put a microscope on the bankruptcy court district for San Diego.  There is a decision back in 2003 saying inherited IRAs don’t have asset protection.  However in August of 2010 a judge in the exact same court said inherited IRAs are protected in bankruptcy.

Why the difference?  The realistic answer is 2 different judges with 2 different opinions.  The other big difference is the different ways the debtors tried to have their IRAs exempt in bankruptcy.

Under the bankruptcy code debtors are allowed to claim that certain assets are “exempt”, that is to say that creditors can’t take those assets away.  So if you have a $500K IRA and it is considered exempt, you can go bankrupt, wipe out your debts, leave bankruptcy and still have a $500K IRA available to start over.   The challenge is that while bankruptcy is federal law, the bankruptcy law says that states can require debtors to use the state law when determining what is and isn’t exempt.

Oh yeah, in the case of certain assets, no matter what the state law says about exemptions, federal law might “trump” the state laws.  Such is the case of exempt status of IRAs in bankruptcy, you are supposed to use state law unless federal law is better.

Starting to get confused?  Good that means you’re human.

In the 2003 case the debtor claimed their inherited IRA was exempt using the state law exemptions, Section 703.140(b)(10)(E) .

(E) A payment under a stock bonus, pension, profitsharing, annuity or similar plan or contract on account of illness, disability, death, age, or length of service. . .

When the judge analyzed the law they came to the conclusion that while the IRA in the heads of the original owner might have fit that definition, once the original owner died and passed the IRA to the new beneficiary, the inherited IRA was no longer similar to a pension, profit sharing, or annuity payment.  Thus the inherited IRA was not exempt in bankruptcy.

In the August 2010 case the debtor’s attorney initially claimed the state exemption for the inherited IRA, but when the bankruptcy trustee put them on notice they were going to try to contest the exempt status of the inherited IRA, the debtor switched to the federal exemptions.

The reason for the switch is the federal laws merely require the plan to be a “retirement plan” and that it is exempt from the relevant sections of the tax code.  The judge in this case determined that the plan was a retirement plan in the hands of the original owner, and its status as a retirement plan stuck with it when it became an inherited IRA.  Thus the judge determined that inherited IRAs are exempt under the federal exemptions.  (By the no one brought up the issue as to if the IRA was still qualified under the code.  That is going to be a very big issue in the years to come.)

So what is the take away from this lesson?  Reasonable minds disagree and this area of the law is far from settled.  There is no binding precedent.  There could be 2 different debtors in San Diego going bankrupt, with the exact same IRAs inherited from the exact same person, getting different judges in bankruptcy, with one keeping their inherited IRA, the other losing their inherited IRA.

The law is not as black and white as people think it is, there are all sorts of nuances based upon everyone’s different situation.  If you have an inherited IRA, or any IRA for that matter, you need to establish a plan on how to protect it before some tragic event causes you to have to consider its protected status in bankruptcy.