The Lunar Landscape of Bankruptcy Protection for Inherited IRAs | Ed Slott and Company, LLC

The Lunar Landscape of Bankruptcy Protection for Inherited IRAs

By Jeremy T. Rodriguez, JD
IRA Analyst
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When a legal question is clear, I like to imagine the landscape like the great plains of the midwestern United States.  The land is flat and lush, meaning problems are easily identified and the area can be easily traversed. On the other hand, when the question isn’t so clear, the terrain reminds me of the moon; rocky, dark, desolate, and full of potholes and craters.

Naturally, we hope that every legal issue we encounter is like the rolling plains of the breadbasket of America. Unfortunately, that is not always the case. And such is the situation when it comes to the protection of inherited IRAs in bankruptcy court. We were recently reminded of that in a January 2019 bankruptcy court decision out of Idaho where the court refused to follow the U.S. Supreme Court! Before unpacking that decision, we need a little background and a quick history lesson.

First the background. When it comes to IRAs that you own (meaning accounts that you opened and contributed to or rolled money into) the rules are clear. Those assets are protected in bankruptcy court up to a certain limit. Currently the limit is $1,283,025. That limit was last set in 2016 and is updated every three years, so expect that to change soon. Assets in a qualified plan are fully protected and do not have a dollar limit. Moreover, any qualified plan assets that you roll into an IRA do not count towards the IRA limit and continue to receive unlimited protection in bankruptcy court.

However, with inherited IRAs, the rules weren’t so clear until 2014 when the U.S. Supreme Court issued the decision of Clark v. Rameker. There, the highest court in the land held that inherited IRAs were not “retirement plans” under federal bankruptcy law, and thus were entitled to zero protection. That means the assets in an inherited IRA can be used to satisfy creditor claims. Afterwards, we saw several bankruptcy courts follow this reasoning, including courts in New York and Illinois. Which makes sense, because usually when the U.S. Supreme Court issues a decision, it’s the law of the land and essentially settles a previously unresolved issue in all circumstances.

But bankruptcy court is different. Why? Well, that’s where our history lesson comes into play. Way back in 1978, when the Bee Gees “Stayin’ Alive” hit ruled the airwaves, the two houses of Congress were locked in a battle over bankruptcy reform. One of the hot button issues were exemptions; meaning assets that a creditor cannot touch. The Senate wanted state law to govern bankruptcy exemptions. The House wanted to give debtors the ability to choose between federal law or state law. The result was a compromise where federal law applied in all bankruptcy cases unless the state opted out.

Which brings us to the Idaho decision, entitled In re Arehart. As you can probably suspect, Idaho opted out of the federal exemptions, unlike Wisconsin, where the Clark v. Rameker decision was decided. That means Idaho law controls the determination of whether an inherited IRA is protected in bankruptcy court. This essentially means that the U.S. Supreme Court decision in Clark, which was based on federal law, is meaningless! The Arehart court acknowledged the Clark decision, but pointed out that Idaho law was much more expansive then the federal exemption.

In fact, the Idaho courts had previously addressed this issue and determined that inherited IRAs were protected under Idaho bankruptcy exemption law. Therefore, the Arehart Court ignored the Clark decision and the inherited IRA was protected from Ms. Arehart’s creditors.

So, the takeaway from this discussion is relatively clear. If you, or someone you know, is headed towards bankruptcy, take a step back and survey the landscape before filing that petition. If the only IRAs you have are those that you own, then the law is clear, and you can proceed with the filing knowing that a certain limit is fully protected from creditors. However, if you have an inherited IRA, you need to do some extra digging into your state’s law. If your state did not opt-out, and applies federal law, then the Clark decision will control, and the inherited IRA will not be protected.

On the flip side, if your state has opted out, then state law will apply. You’ll have to understand what the state’s exemptions are, and whether any previous bankruptcy court cases in your state addressed the inherited IRA question. Even that might not give you a clear picture. In the end, inherited IRAs are big craters in bankruptcy court, and you must know the rules before filing if you want to avoid that pitfall.




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