Individual Retirement Accounts (IRAs) are generally exempt from claims in bankruptcy. Under Bankruptcy Code Section 522(d)(12), an individual debtor may exempt from property of the bankruptcy estate “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.”1 Although New York has opted out of the federal exemptions, New York law provides a similar exemption for individual retirement accounts. Section 282 of New York’s Debtor and Creditor Law allows an individual debtor domiciled in the State of New York to exempt from the property of the estate, personal and real property exempt from application to the satisfaction of money judgments under Section 5205 of the CPLR.2 That section of the CPLR provides in relevant part that “all property while held in trust for a judgment debtor, where the trust has been created by, or the fund so held in trust has proceeded from, a person other than the judgment debtor, is exempt from application to the satisfaction of a money judgment.” Although an IRA would proceed from the debtor, Section 5205(c)(2) specifically includes “all trusts, custodial accounts, annuities, insurance contracts, monies, assets or interests established as part of, and all payments from, either any trust or plan, which is qualified as an individual retirement account under section four hundred eight or section four hundred eight A of the United States Internal Revenue Code of 1986.”3 These rules become unclear in the context of inherited IRAs.
If the owner of an IRA designated his/her spouse as a beneficiary of his/her IRA and dies before exhausting that account, the surviving spouse may elect to either “rollover” the decedent’s IRA into an IRA owned by the surviving spouse, or treat the decedent’s IRA as the spouse’s own IRA.4 Where the surviving spouse makes the IRA his/her own, the benefits of creditor protection will apply under both the federal and New York State exemptions.
However, this “rollover” is not possible where the designated beneficiary is not the IRA owner’s spouse, in which case the designated nonspouse beneficiary may make a trustee-to-trustee transfer of the inherited amount to a new IRA in the name of the decedent for the benefit of the nonspouse beneficiary. In addition, a popular financial strategy is to bypass a surviving spouse and allow an IRA to pass to younger generations using their life expectancy for the minimum required annual distributions. This so-called “stretch IRA” can achieve tremendous post-tax accumulation especially when grandchildren may be measuring lives. A question arises as to bankruptcy and creditor protection of these increasingly popular vehicles.
Recent Bankruptcy Cases Involving Inherited IRAs
In the span of two months early this year, two Bankruptcy Courts confronted the issue of whether inherited IRAs are exempt under federal bankruptcy law. Of course, the two courts came to drastically different conclusions. The Eastern District of Texas in In re Chilton5 upheld the Chapter 13 Trustee’s objection and denied exemption of the wife’s inherited IRA. In that case, the debtor was the beneficiary of her mother’s IRA. When the debtor’s mother died, the debtor established an IRA for the purpose of receiving the funds from her mother’s IRA. None of the funds or assets in the account were the result of contributions made by the debtor. When the debtor filed for relief under the Bankruptcy Code and claimed the inherited IRA as exempt, the Trustee objected to the debtor’s claimed exemption. In determining whether the inherited IRA was exempt under Section 522(d)(12), the Bankruptcy Court engaged in a two-part test: “First, the Court must determine whether the funds are ‘retirement funds.’ Second, if the funds are retirement funds, the Court must determine whether the funds are exempt from taxation under the applicable provisions of the Internal Revenue Code.” The Court answered both parts in the negative finding that (1) the funds contained in an inherited IRA are not funds intended for retirement purposes but, instead, are distributed to the beneficiary of the account without regard to age or retirement status and (2) while the transfer of an IRA into an inherited IRA is exempt from taxation under Section 402(c)(11) as an eligible rollover, it does not fall within the definitional scope of Section 408(e)(1). Therefore, the Court concluded that the inherited IRA was not exempt under federal bankruptcy law.
Meanwhile, a similar fact pattern was being considered by the U.S. Bankruptcy Appellate Panel of the Eight Circuit in In re Nessa.6 On appeal from the District Court of Minnesota, the Circuit Court affirmed the lower court’s holding that inherited IRAs are exempt under federal bankruptcy law. In grappling with the two-prong test articulated in Chilton, the Court in Nessa determined that not only was the inherited IRA a retirement fund within the purview of the Section 522(d)(12), but it was also exempt from taxation under Section 408 of the Internal Revenue Code. The Circuit Court found that plain meaning of Code Section 522(d)(12) requires only that the account be comprised of retirement funds, and does not specify that they must be debtor’s retirement funds. Moreover, the Circuit Court held that Section 408(e) of the Internal Revenue Code provides that “any individual retirement account is exempt from taxation” and therefore it does not distinguish between an inherited IRA and traditional types of IRAs. In distinguishing In re Chilton, the Circuit Court in Nessa stated that “the Chilton court’s conclusion is erroneous because inter alia, it fails to take into account section 522(b)(4)(C) of the Bankruptcy Code…and in fact it would make that section totally meaningless.” That section states that “a direct transfer of retirement funds from 1 fund or account that is exempt from taxation under section…408…of the Internal Revenue Code of 1986,…, shall not cease to qualify for exemption under…subsection (d)(12) be reason of such transfer.” Therefore, the direct transfer of funds from an IRA into debtor’s inherited IRA did not destroy the debtor’s ability to claim the funds exempt under Bankruptcy Code Section 522(d)(12).
Are Inherited IRAs Exempt in New York State?
According to the New York statute, New York State, which opted out of the federal exemptions, exempts “all trusts, custodial accounts, annuities, insurance contracts, monies, assets or interests established as part of, and all payments from, either any trust or plan, which is qualified as an individual retirement account under section four hundred eight…of the United States Internal Revenue Code of 1986.”7 This language raises the question of whether an inherited IRA qualifies as an exempt IRA in New York State. If the analysis in In re Chilton is applied, it would appear that such accounts would not be protected from creditors in bankruptcy. The more appropriate analysis, however, is presented by the Eighth Circuit in In re Nessa in that Section 522(d)(12) of the Bankruptcy Code makes no distinction or requirement as to the intent of establishing the account, i.e., there is no requirement in the statute that the account be established for the sole purpose of retirement. Moreover, the Nessa Court more accurately presented the fact that an inherited IRA is a tax exempt account and that the language of Section 522(d)(12) applies to the account itself and not to the taxable minimum required distribution.
The New York statute is inclusive and its broad scope would likely encompass inherited IRAs. Specifically, the New York statute makes no mention or requirement of “retirement funds” or exemption from taxation. The sole requirement seems to be inclusion in Internal Revenue Code Section 408. Internal Revenue Code Section 402(c)(11)(A) generally describes the classification of an inherited IRA. For plan years beginning after December 31, 2009, the statute has been amended so that “(i) the transfer shall be treated as an eligible rollover distribution, (ii) the individual retirement plan shall be treated as an individual retirement account … (within the meaning of Section 408(d)(3)(C))…”(emphasis added).8 Per-haps this amendment will now help clarify that these accounts will qualify for exemption, at least in New York.
Robert Barnett is a Partner at Capell Barnett Matalon & Schoenfeld LLP in Jericho, New York, where he heads the Tax and Estate Planning Departments. Renato Matos is an associate of the firm active in the Tax and Corporate Departments.
1. Bankruptcy Code § 522(d)(12).
2. New York’s Debtor and Creditor Law § 282.
3. C.P.L.R. § 5205.
4. I.R.C. § 408(d)(3)(c).
5. 426 B.R. 612 (Bankr. E.D. Tex. Mar. 5, 2010).
6. 426 B.R. 312 (U.S. BAP 8th Cir. Apr. 9, 2010).
7. I.R.C. § 5205(c)(2).
8. I.R.C. § 402(c)(11)(A)(i).
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