By Robert L. Moshman

 

It is not often that the Supreme Court provides a clear rule on any aspect of financial planning (or even graces our niche with a passing reference), so these occasions call for special attention.

On June 12, 2014, the Supreme Court’s decision in Clark v. Rameker clarified that an inherited IRA is not a protected retirement fund for bankruptcy purposes.

Here, we analyze the decision and its impact on planning issues and review the applicable rules and caveats that apply to inherited IRAs.

Note: The following discussion of IRAs is about traditional tax-deferred IRAs only and does not attempt to cover inheritance or bankruptcy considerations that pertain to any other qualified retirement plan.

The Takeaway

Let’s skip past the decision itself and get right to the financial planning implications of Clark v. Rameker.   

Sadly, more taxpayers are likely to make costly mistakes and miss valuable opportunities with their inherited IRAs on their own than those who will have inherited IRAs exposed to bankruptcy creditors. So the real significance of the Supreme Court’s decision in Clark v. Rameker for most people is that it directs attention to the overlooked benefits of stretch IRAs and the many rules that can trip up taxpayers. Planners need to be especially vigilant in making sure that clients are made aware of IRA opportunities and typical pitfalls when advising on the designation of beneficiaries for IRAs or the tax deferral options that are available to those beneficiaries who inherit IRAs.

How will Clark actually affect planning?

Truly, everyone planning to name a beneficiary to an IRA—and everyone inheriting an IRA—needs to have a system with clear rules so that an accurate understanding can be obtained about how inherited IRA assets will be treated in the event of a bankruptcy.

Granted, IRA owners don’t normally base their beneficiary designations on which family members they think might go bankrupt. And, for practical purposes, beneficiaries of an inherited IRA may not have many viable options for protecting an inherited IRA before declaring bankruptcy. At the very least, spending down inherited IRA assets in lieu of other protected retirement assets would be permitted and prudent.

One remaining uncertainty under Clark is how spousal IRAs will fare. Even assuming that spousal IRAs are an exempt asset for bankruptcy, a spouse may be exposed to creditors until the election is made to roll the inherited asset over. In addition, transfers with knowledge of an impending bankruptcy are fraudulent, and this may include spousal IRAs as well. In fact, under §548(e) of the Bankruptcy Code, a 10-year look back would apply to a spouse’s conversion of a non-protected asset to a protected asset. It is possible that future rulings may treat inherited spousal IRAs as non-exempt for bankruptcy purposes under 11 U.S.C. 522(b)(3)(C).

On the other hand, however, there are statutes in a handful of states that may exempt spousal IRAs. For example, Missouri law specifically exempts inherited retirement plans from bankruptcy creditors.

In the final analysis, relying on retirement assets as safe havens from creditors is a highly flawed strategy from every direction. There are mandatory distributions that will be taxed and possibly subject to creditors upon distribution. IRA assets are not controlled and protected by trustees exercising discretion over irrevocable asset protection trusts. To state the obvious, IRAs simply are not trusts and cannot provide the same benefits.

As covered in the September 2013 issue of The Estate Analyst, we interviewed notable estate planner Philip J. Kavesh, Esq. of The Ultimate Estate Planner, Inc. on his specially designed IRA protection trust. That device, as vetted via private letter ruling, has a unique “toggle” feature that allows the trust protector to reset the asset protection level for each beneficiary with 20/20 hindsight after the IRA owner has died. Here is an excerpt from that interview.

Q: Why is a trust useful for retirement assets?

A: IRA trusts aren’t for everyone with retirement assets but can be useful instead of—or in combination with—testamentary trusts. With the right IRA trust, income tax savings can be maximized while also providing protection from creditors.

Q: Is it preferable to utilize a stand-alone trust to receive the IRA assets?

A: There is some risk involved in doing it wrong and ending up with a five-year payout. The objective is to defer income tax by maximizing the “stretch-out.” Setting up a beneficiary sub-share trust inside a living trust that lacks firewalls against bad provisions elsewhere in the living trust may cause it not to qualify for the stretch-out under IRS regulations. To ensure the stretch-out, we use a stand-alone trust that has already been approved by the IRS. There are also some practical benefits. Beneficiaries are less likely to empty out a separate IRA trust designed to maximize stretch-out. Beneficiaries often run to the custodian and withdraw all of the funds without realizing they’ve wasted the stretch-out ability. That is a tragic mistake. There is no 60-day “put-back” provision to save it. I’ve heard that as many as 85% of IRAs get inadvertently cashed out in the first year after the owner’s death.

Inherited IRAs

Reasonable minds can differ on whether an inherited IRA should no longer be considered a retirement asset for bankruptcy purposes. Notwithstanding the unanimity of the Supreme Court in Clark v. Rameker, other Courts have reached the opposite conclusion.

From the petitioner’s perspective in Clark, the result has to be disappointing. The protected status of retirement funds appeared to be directly applicable to the IRA they inherited. Let us count the ways.

First, U.S.C. sections 522(b)(3)(C) and 522(d)(12) allow a debtor to exempt “retirement funds” from bankruptcy creditors if those funds are exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986. The “funds” in Clark originated with the individual retirement account of Ruth Heffron, who established a traditional IRA in 2000. Clearly, these were retirement funds prior to the original owner’s death. The funds were also placed in an IRA after they were inherited. Those funds continued to be exempt from taxation under §408. Ergo, §522(b)(3)(C) would appear to be directly applicable.

Second, when an IRA is inherited, the beneficiary can elect to extend tax deferral for the assets in the inherited IRA and have annual distributions from the IRA based on their own life expectancy or, in the case of a spouse, roll the IRA over and treat themselves as the owner. These decisions extend the tax deferral benefits associated with retirement funds.

Third, the application of sections 522(b)(3)(C) and 522(d)(12) to inherited IRAs was not a first-time experiment by Heidi Heffron-Clark. Inherited retirement funds had already been exempted in prior bankruptcy cases.

For example, in, In re Tabor, United States Bankruptcy Court, M.D. Pennsylvania (2010), decedent Bernice Simpson died leaving four IRA accounts that named her son and daughter as beneficiaries. After her death in 2004, the four IRAs were divided between her children, and her daughter’s share was transferred to an inherited IRA account that named the daughter, Deborah Simpson, as the beneficiary. Several distributions were made from the inherited IRA, and there was about $105,000 in the inherited IRA account in 2007 when Deborah Simpson filed for bankruptcy and claimed the IRA account as exempt under section 522(b)(3)(C) and Pennsylvania law. Both the Bankruptcy Rules and Pennsylvania law reference Internal Revenue Code 408 for the determination of which funds are exempt.

The Bankruptcy Court noted that exemptions are presumed valid under IRC section 11 U.S.C. § 522(l), unless a party in interest objects and that the objecting party has the burden of proving that the exemption is not valid under Federal Rules of Bankruptcy P. 4003(c). Under section 408(d)(3), an IRA distribution is not taxable if it is paid into or “rolled over” into another qualified retirement plan.

The Court noted the distinctions in tax treatment of an owner’s IRA from a beneficiary’s inherited IRA. However, the debtor argued that the inherited IRA need only be subject to section 408 to be exempt from bankruptcy. The Court also noted cases from Texas, Oklahoma, and Alabama in which inherited IRAs were ruled not exempt from bankruptcy because of different tax treatments than owned IRAs.

However, the Court in In re Tabor noted that these decisions preceded the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8 (2005)(“BAPCPA”),  in which Congress codified the case precedent of Patterson v. Shumate, 504 U.S. 753 (1992),  and expanded the protection afforded to IRAs.

In Shumate the 4th Circuit had protected retirement funds based on the nonalienation provision of ERISA-qualified plans. Under BAPCPA, “the exemption provisions of §522(b)(3) were added to include retirement funds to the extent that the funds were in an account exempt from taxation under specified sections of the IRS Code, without a determination of whether the funds were ‘reasonably necessary for support of the debtor or the debtor’s dependents.’ 11 U.S.C. § 522(b)(3)(C).”

The In re Tabor Court ultimately decided to follow the Eighth Circuit Bankruptcy Appellate Panel decision in In re Nessa. 426 B.R. 312 (B.A.P. 8th Cir. 2010). In that case, the Eighth Circuit Bankruptcy Appellate Panel ruled in favor of an inherited IRA being exempted from bankruptcy creditors. In In re Nessa, the Bankruptcy Appellate Panel concluded that the statute only required that the funds be “retirement funds,” without specifying that the funds be the debtor’s retirement funds.

It then concluded that, “Debtor may exempt the funds in her inherited IRA because, like an ordinary IRA, the funds were deposited in the original custodial account as retirement funds, and they are exempt from federal taxation until the funds are withdrawn.” A similar result was reached by the 5th Circuit Court of Appeals in, In re Chilton, 674 F.3d 486 (2012).

Clark v. Rameker

In re Nessa is notable for setting up the conflict between the 8th Circuit and the 7th Circuit’s decision in Clark v. Rameker, which provided jurisdiction for the Supreme Court’s involvement.

The inherited IRA in Clark v. Rameker was initially found to not be exempt from bankruptcy creditors by the Bankruptcy Court. In re Clark,450 B. R. 858, 866 (WD Wisc. 2011).The District Court reversed. The Seventh Circuit Court of Appeals reversed the District Court. The Supreme Court has now affirmed the Seventh Circuit in a unanimous decision.

Under 26 U.S.C. § 408(d)(3)(C)(ii)(I-II), an IRA is treated as an inherited IRA if it is inherited at the owner’s death by someone other than the owner’s spouse. At Ruth Heffron’s death in 2001, the $450,000 IRA was inherited by her sole beneficiary, her daughter, Heidi Heffron-Clark. Ms. Heffron-Clark commenced taking monthly distributions from the inherited IRA. The IRA had $300,000 in it when she and her husband filed for bankruptcy in 2011. At that time, the funds were still in an account referred to as an IRA, i.e., with “retirement” in the name of the account. These funds continued to be tax deferred under section 408 of the IRS Code. Because they are called retirement funds and are exempt from taxation under section 408, it follows that sections 522(b)(3)(C) and 522(d)(12) are applicable.

Justice Sotomayor identified three aspects of inherited IRAs that distinguish them from an owner’s retirement funds.

Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement. First, the holder of an inherited IRA may never invest additional money in the account. 26 U.S.C. §219(d)(4). Inherited IRAs are thus unlike traditional and Roth IRAs, both of which are quintessential ‘retirement funds.’ For where inherited IRAs categorically prohibit contributions, the entire purpose of traditional and Roth IRAs is to provide tax incentives for accountholders to contribute regularly and over time to their retirement savings.”

The analysis can also be argued the other way. Assets exempt from taxation under IRC §408 incentivize self-reliance and savings. An inherited IRA is still an IRA, and the “R” in that acronym stands for retirement. But whether we agree with the decision in Clark v. Rameker or not, at least we now have clear rules upon which we can base our planning decisions.

IRA Distribution Basics

Under normal circumstances, barring qualification for an exemption, a distribution from a regular IRA prior to age 59.5 will result in the distribution being taxed to the owner as current income and being subject to a 10% penalty. At age 70.5, required minimum distributions (RMDs) must commence. The deadline is April 1st of the year following the year in which the IRA owner turns 70.5. RMDs consist of the account balance at the end of the previous year divided by the owner’s life expectancy on a chart provided by the IRS.

After an IRA owner dies, there are three major factors that determine how the IRA is treated.

1)    Inheritances by spouses are treated differently than inheritances by others.

2)    IRAs that have already commenced distributions are treated differently than IRAs that have not commenced distributions.

3)    Traditional IRAs are treated differently than Roth IRAs.

 

NON-SPOUSES: If you inherit an IRA from someone other than a spouse, you can cash in the IRA and take the assets. You will then be responsible to pay income tax on the distributed assets as part of your current income. No 10% penalty applies because the reason for the distribution is the IRA owner’s death. Note: If the deceased owner had already turned 70.5 prior to death and failed to take a required minimum distribution prior to December 31 of the year of death, the estate will need to take the distribution to avoid a 50% penalty.

A non-spouse may not treat an inherited IRA as his or her own or defer distributions from the IRA or make additional contributions to the inherited IRA. However, a non-spouse can maintain an inherited IRA account and will then be required to immediately commence withdrawing annual distributions based on his or her own life expectancy.

Example: Harry and Taylor were in love but did not marry. They broke up and are never, ever getting back together. Yet, when Harry died, he left his $300,000 IRA to Taylor. Taylor can keep the inherited IRA account but must commence distributions immediately, based on her own life expectancy, even though she is not yet 59.5 years old. The annual distributions are not subject to the 10% early withdrawal penalty, but they are taxed as ordinary income to Taylor in the year of distribution.

Because Taylor is only 24 years old and has a life expectancy of about 59 years, she can distribute the $300,000 over her life expectancy with about $5,084 per year. In this manner, she can stretch the duration of the tax-deferral feature of the inherited IRA, hence the term “stretch” IRA. The younger the beneficiary, the longer the stretch of the tax-deferral period and the greater the tax-deferred growth of the IRA assets.

Non-spouses also have another option of distributing the inherited IRA over five years following the original owner’s death. For a large IRA, that might push the beneficiary into a higher tax bracket. However, that would not be a problem for Roth IRAs because there is no tax upon distribution. Beneficiaries inheriting an IRA must take the first required minimum distribution by December 31st of the year following the year of the IRA owner’s death.

Caveats: Failure to take that first distribution on time will void the full stretch of the required minimum distributions over the life span of the beneficiary and the default to a five-year payout. Another pitfall to avoid is failing to designate an appropriate beneficiary on the IRA’s beneficiary designation form.

Many people are also unaware that their Will cannot modify an existing beneficiary designation form. If that form doesn’t name beneficiaries or names the estate, the opportunity for a stretch IRA will be wasted. If the beneficiary designation form names a trust, that trust needs to be drafted to enable specific beneficiaries to fully stretch out the tax-deferral options and should also provide the trustee with sufficient notices, instructions, and authority so that it is carried out in the required time.

SPOUSES: A surviving spouse who inherits an IRA from a deceased spouse has all of the options available to a non-spouse, plus some additional options. The surviving spouse can take an immediate distribution of the IRA and pay taxes currently or choose to be treated as a beneficiary and take distributions based on his or her own life expectancy.

However, a surviving spouse can also choose to be treated as an IRA owner. If the deceased spouse had already turned 70.5 and had commenced taking required minimum distributions, the surviving spouse will then continue to take annual distributions based on his or her own life expectancy. If the deceased spouse had not yet commenced taking distributions, the surviving spouse can then wait until he or she turns 70.5 to commence taking distributions. If a surviving spouse inherits a Roth IRA, distributions need not commence at all.

Note: Distributions from an inherited Roth IRA are generally tax free, unless the IRA was established less than five years prior to death, in which case the earning on the IRA contributions would be subject to taxation.

 

The Estate Analyst. July 2014.