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Highlighting the Benefits of IRA Trusts

Earlier this year, the United States Supreme Court issued a ruling in the case of Clark v. Rameker that will have a significant impact on what happens when Individual Retirement Accounts (IRAs) are inherited. Specifically, the court ruled that money in an IRA is not considered to be “retirement funds” for bankruptcy purposes.


The circumstances of the case are as follows: back in October 2010, the Clarks filed for bankruptcy. When they did so, they claimed that the $300,000 IRA that Heidi Clark inherited was exempt from their bankruptcy estate. In doing so, they cited Section 522 of the Bankruptcy Code. Which specifically exempts tax-exempt retirement funds from a bankruptcy estate. This interpretation of the bankruptcy code was objected to by the bankruptcy trustee, as well as representatives for several of the Clarks' creditors. Their position was that these funds could not be considered “retirement funds” within the meaning of Section 522.

The Bankruptcy Court agreed with the trustee and creditors, but a US District Court overruled them. According to that decision, inherited IRAs are exempt precisely because they retain their character as retirement funds. However, the US Court of Appeals for the Seventh Circuit reversed that ruling, and the Supreme Court agreed with the Seventh Circuit. Both decisions held that the funds contained in an inherited IRA had not been set aside for the debtor's retirement, and are therefore not considered “retirement funds” exempted by Section 522.

In part, the Supreme Court's decision is based on the concept that “[i]nherited IRAs do not operate like ordinary IRAs.” For example, while a traditional IRA will impose a 10 percent penalty on funds withdrawn before age 59 ½, those who inherit an IRA are allowed to withdraw funds from that account at any time without penalty. In fact, the owner of the inherited IRA has five years after the original owner staff to either withdraw the entire account balance or set up minimum annual distributions from the account. Also, unlike the original owner of the IRA, the owner of an inherited IRA can never add additional funds to that account.

In writing the opinion, Justice Sonia Sotomayor noted that “the possibility that some investors may use their inherited IRAs for retirement purposes does not mean that inherited IRAs bear the defining legal characteristics of retirement funds. Were it any other way, money in an ordinary checking account (or, for that matter, an envelope of $20 bills) would also amount to “retirement funds” because it is possible for an owner to use those funds for retirement.”

This declaration regarding the status of inherited IRAs should serve as a reminder that an important estate planning tool is the IRA trust, also known as a “conduit trust.” With this type of trust, very technical provisions allow the trustee to manage the IRA for the benefit of the beneficiary, while also preserving the ability to extend the tax deferred growth of the IRA throughout the life of the beneficiary. By doing this, the beneficiaries will experience the tax advantages associated with being the beneficiary of the IRA, as well as the advantages inherent in leaving a gift in trust, which would effectively protect the assets of the trust from creditors, even  in cases of bankruptcy. 

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