Updated: Oct 22, 2021
One of the greatest areas of controversy regarding the exemption for individual retirement accounts (IRAs) is the inherited IRA. If a would-be bankruptcy debtor has inherited an IRA from a relative, as often happens between spouses and parents and children, can he or she exempt that IRA as if it were an IRA that they had funded? Or are inherited IRAs treated as most other inherited assets, subject to nominal, if any, exemption in bankruptcy? Whether a bankruptcy debtor may exempt an inherited IRA as one’s own IRA depends on whom they inherited the account from and what they did with the IRA upon inheritance.
Most IRAs are exempt when one files bankruptcy, meaning the retirement account is protected against creditor claims when a bankruptcy is filed. Stated otherwise, the debtor may file bankruptcy, receive a discharge of debts and keep their IRA account intact. This exemption for IRAs includes employer-sponsored IRAs, such as simplified employee pension plans (SEPs) and simple IRAs, as well as IRAs rolled over from 401(k), 403(b), or 457 (government) plans. While the exemption is currently limited at $1,171,650, the IRA exemption nevertheless applies whether the debtor elects the federal or Minnesota state exemption scheme. However a debtor should not to assume that all IRAs within the dollar limits are always exempt in bankruptcy, particularly if that IRA account was set up by someone other than themselves. In other words if the IRA is a result of a transfer, that IRA account may not be exempt in bankruptcy.
The availability of the exemption for an inherited IRA lies in from whom the IRA was inherited. In 2014, the U.S. Supreme Court issued a decision in Clark v Rameker holding that inherited IRAs generally may not be exempted via the IRA exemptions provided under the Bankruptcy Code or state statute. However the case carved out an exception for IRAs inherited by a spouse. In essence, Clark v Rameker holds that while inherited IRAs are not exempt, there is a singular exemption for an IRA is inherited by one’s spouse (i.e., the bankruptcy debtor is the surviving spouse) provided the surviving spouse treats that IRA as if it is their own IRA by rolling it over directly into their own IRA. The rollover is critical to claiming the exemption, since by rolling over the IRA into one’s own account, the surviving spouse demarcates the IRA as one’s own IRA (i.e., not as an inherited IRA) under both the Internal Revenue Code and the Bankruptcy Code. The opinion of Clark v Rameker, outlines the facts for creating the exception to the rule otherwise that inherited IRA’s cannot be exempted as one’s own IRA:
The third type of account relevant here is an inherited IRA. An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. See §§ 408(d)(3)(C)(ii), 408A(a). If the heir is the owner’s spouse, as is often the case, the spouse has a choice: He or she may “roll over” the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA (subject to the rules discussed below). See Internal Revenue Service, Publication 590: Individual Retirement Arrangements (IRAs), p. 18 (Jan. 5, 2014). When anyone other than the owner’s spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account. Clark v. Rameker, 134 S. Ct. 2242, 2245, 189 L. Ed. 2d 157 (2014)
This reasoning in Clark v. Rameker aligns with the singular exception created in the Internal Revenue Code, which treats an IRA as “inherited” only when the individual acquired such account by reason of the death of another individual, and such individual was not the surviving spouse of such other individual. See 26 U.S.C. § 408(d)(3)(C)(ii). See also Internal Revenue Service, Publication 590: Individual Retirement Arrangements (IRAs), p. 18 (Jan. 5, 2014)(“If you inherit a traditional IRA from your spouse… you can… [t]reat it as your own by rolling it over into your IRA.” This IRC reference was the exclusive basis for reasoning used by the Supreme Court in deciding against the debtor’s claimed exemption in Clark v Rameker, since the debtor in that case was not the surviving spouse of the IRA’s owner and therefore could not exempt the IRA no matter what she did.