Let’s assume that spouse A and spouse B have been married, and that A has contributed annually to an IRA account. When A passed, A’s IRA designated B as the surviving spouse beneficiary for the account. When B passed, though, the account was transferred in equal parts to the children, X and Y. The IRA in the children’s hands is known as an “inherited IRA.” Are the funds within this inherited IRA still “retirement funds,” or has the generational transfer or the new account title morphed these funds into “non-retirement funds”? The question may seem academic, but it has significance if either X or Y file bankruptcy holding the inherited IRA.
The rate of occurrence of an inherited IRA in a bankruptcy case will likely increase in the near future, as baby boomers who have accumulated IRAs pass these accounts to their children. When the account passes from the IRA account originator or the surviving spouse to the second generation, an “inherited IRA” is created for the benefit of the devisee. If a devisee then files for bankruptcy, the question arises whether the assets within the inherited IRA are included in the bankruptcy estate. Section 522 of the Bankruptcy Code provides a federal exemption for “retirement funds,” but the Code also allows states to opt of the federal exemption and adopt their own exemption, opt of the federal and not adopt a state exemption, or not opt out and allow state residents to use the federal exemption. Maine has opted out and adopted a generous state exemption using nearly identical language to the Bankruptcy Code. Maine’s statutory language may require judicial interpretation to clarify the question of inherited IRAs, especially in light of a recent circuit split on the federal statute.
In the last few years, circuit Courts of Appeals have split on whether the Code’s exemption for “retirement funds” includes inherited IRAs. Most bankruptcy courts have concluded that inherited IRAs are not exempt, whereas until recently, virtually all federal appellate courts had ruled that the inherited IRA is outside of the estate. However, a recent opinion from the Seventh Circuit authored by Judge Richard Posner held that the inherited IRA is non-exempt, and, therefore, within the reach of creditors. The panel requested en banc review due to the fact that the opinion represented a new circuit split. The Seventh Circuit declined the review. The case has been granted certiorari, and a Supreme Court decision on the issue may settle the issue.
If you or someone you know may be contemplating filing bankruptcy, please contact me to discuss the situation. Given that a decision from the highest court in the land may be forthcoming, the timing of filing the bankruptcy petition may be critical.