IRAs and Qualified Plans are an increasing portion of our clients’ wealth. The advantages of the income tax deferral are well-known. This month’s Alert looks at developments regarding the creditor protection such plans provide, not only for the contributor, but also for those who inherit them.
The federal government and most states extend creditor protection to IRAs and other retirement accounts. The extent of this protection has been clear with regard to IRAs and other retirement accounts established by the contributing debtor. But, the extent of creditor protection for Inherited IRAs has been less clear. Early court decisions held that protection was not available for debtors with Inherited IRAs, but more and more courts are now holding to the contrary. With this new development, it becomes even more important than ever for clients with significant retirement assets to consult with an estate planning attorney with special knowledge of the federal and state laws dealing with estate and income taxation, retirement plans, and asset protection in order to preserve this important benefit for their family.
In the case In re Mathusa, No. 6:10-bk-13336-KSJ (March 28, 2011) the debtor, Marilynn Mathusa, was designated as the beneficiary of an IRA which had belonged to her deceased mother. Marilyn followed the required formalities to make a trustee-to-trustee transfer of her mother’s IRA into an inherited IRA. When she filed for bankruptcy several years later, she claimed an exemption in the bankruptcy proceedings. The Bankruptcy Trustee argued that an Inherited IRA did not qualify for an exemption under either federal or state law.
The United States District Court for the Middle District of Florida held that the federal exemption statutes provide that a debtor may claim an exemption for retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Internal Revenue Code sections dealing with retirement accounts. In its opinion, the court focused on the reasoning of the Eighth Circuit in In re Nessa, 426 B.R. 312 (B.A.P. 8th Cir. Apr. 9, 2010). In Nessa, the Court of Appeals concluded that the debtor’s Inherited IRA was exempt under federal law because the assets in an Inherited IRA qualified as “retirement funds” and an Inherited IRA is exempt from taxation under the Internal Revenue Code. The Nessa court further held that federal law does not require the retirement funds to be the debtor’s retirement funds to qualify for exemption. The Mathusa court expressly adopted the reasoning of Nessa. Accordingly, the District Court held that Marilyn’s Inherited IRA was exempt from the claims of her creditors.
Another recent case, In re Thiem, 107 AFTR 2d 2011-529 (Bktcy Ct AZ Jan. 19, 2011), resulted in the United States Bankruptcy Court for the District of Arizona also holding that an Inherited IRA was exempt from the inheritor’s creditors. In that case, Kay Thiem and her sister were named as beneficiaries of their mother’s IRA. Within sixty days of her mother’s death, all of her mother’s IRA was transferred by trustee-to-trustee transfer into an Inherited IRA for the benefit of Kay. Kay took all of her mother’s IRA as an inherited IRA and paid her sister the sister’s share of the IRA using Kay’s own funds.
Five years later, Kay and her husband filed for bankruptcy protection from their creditors. Between the date she transferred her mother’s IRA into her Inherited IRA and the date of her petition for bankruptcy protection, Kay took only the Required Minimum Distributions mandated by federal law from her Inherited IRA. Upon filing for protection from her creditors under bankruptcy laws, Kay claimed an exemption for her Inherited IRA pursuant to the federal Bankruptcy Code and the Arizona exemption for retirement plans under its bankruptcy statutes. The Bankruptcy Trustee objected to the claimed exemption on the grounds that the source of the retirement funds was not Kay, but her mother.
The court indicated that federal and Arizona case law and legislative history did not reveal any useful information regarding the application of the exemption of retirement plan assets by federal and Arizona bankruptcy statutes to an Inherited IRA. The court found that there was no question that the mother’s IRA would have qualified as an exempt IRA under both federal and Arizona law if Kay’s mother had been filing for bankruptcy. The question remaining was whether federal and Arizona law also recognized and extended this asset protection to the IRA once it became an Inherited IRA belonging to Kay.
Because there was no Arizona law on point, the court turned to case law from other jurisdictions. In such jurisdictions, the applicable statutes did not specifically address whether Inherited IRAs were exempt under state law. In reviewing the decisions In re McClelland, 2008 WL 89901 (Bankr. D. Idaho 2008), In re Tabor, 433 B.R. 469 (Bankr. M.D. Pa. 2010), and In re Kuchta, 434 B.R. 837 (Bankr. N.D. Ohio 2010), the Thiem court found the case law in support of an exemption for an Inherited IRA to be convincing. The court disagreed with the courts that denied the exemption stating that even though Inherited IRAs are treated differently under the Internal Revenue Code, they maintain the tax-advantaged attributes of other retirement assets provided for under the Code.
The court held that the plain language of the federal exemption statutes provides that transfers of the type that create an Inherited IRA do not cause a loss of exemption eligibility. In addition, the court did not agree with the cases that required a retirement purpose to obtain exemption because the federal exemption statutes do not require the funds to be those originally belonging to the debtor. See, e.g., In re Chilton, 426 B.R. 612 (Bankr. E.D. Tex. 2010). Instead, the court held that an Inherited IRA that complies with the Internal Revenue Code to be an account that meets the requirements of the Arizona and federal retirement exemption statutes at issue.
There have now been at least a dozen decisions under different state statutes holding that Inherited IRAs are afforded the same asset protection benefits available to IRAs and other retirement plans created and funded with the debtors own funds. Our law firm focuses its practice on estate planning, especially as it relates to large retirement assets and asset protection strategies. As a member of the exclusive nationwide group of estate planning attorneys, the American Academy of Estate Planning Attorneys, we are kept up-to-date on all the new statutes, case law and other developments in the complicated practice areas of estate planning, retirement planning, tax law, and asset protection strategies. You can take advantage of our specialized knowledge by scheduling a free consultation with one of our attorneys for yourself or one of your clients by calling or visiting our website.