By Ryan C. Wood
Once of the most difficult moments during a free consultation with a potential client is when they tell me they borrowed or withdrew money from their 401k or other retirement account to pay off some of their debts. While I commend their effort and attempt to pay their debts I know they would have been better off to have kept the retirement funds in their accounts. The first problem is that they only paid off some of their debts with their hard saved retirement money and not all of their debts, so they are still speaking to me, a bankruptcy attorney in the Bay Area. I can only recommend taking an early withdrawal or cashing out a retirement account if you can become completely debt free. We do not want you to just delay the inevitable and be $20,000 poorer and still file for bankruptcy. If the funds were withdrawn, the second problem usually is that they did not pay the taxes from the balance they withdrew at the time the money was received. They not will have a large tax bill at the end of the year that they cannot afford to pay.
Retirement Funds are Protected When Filing Bankruptcy
The exemptions that protect assets, whether they be the Federal Exemptions, or the exemptions pursuant to state law, the exemptions universally include an exemption to protect tax deferred retirement accounts. Every penny. We filed a Chapter 7 bankruptcy case for an individual who had over $700,000 in an IRA and it was all protected. No one wants to take away your retirement money. Being able to get rid of debts while keeping retirement funds is good for society and supported by the bankruptcy code.
What if the IRA was inherited? Is the inherited IRA still protected or exemptable?
The Supreme Court of the United States recently addressed this issue in Clark v. Rameker, No. 13-299, 2014 BL 162980 (U.S. June 12, 2014). In this case the bankruptcy filer inherited an IRA with a balance of about $300,000. Pursuant to 11 U.S.C. §522(b)(3)(C) the debtor exempted the inherited individual retirement account. The Chapter 7 trustee assigned to the case, William J. Rameker, objected to the claim exemption. The original bankruptcy court ruled that the inherited IRA does not share the same characteristics of a non-inherited IRS and therefore is not protected or exemptable. The District Court reversed and the Seventh Circuit reversed the District Court by agreeing with the original bankruptcy court. The Supreme Court held on June 12, 2014, that the inherited individual retirement accounts are not “retirement funds” within the meaning of 11 U.S.C. §522(b)(3)(C) and therefore cannot be protected.
The justification for this decision is that the inherited IRA has different rules and requirements that are not like traditional retirement accounts. To make matters more complicated when anyone other than the owner of the IRA’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. So for some, they are stuck with this inherited IRA account that they cannot rollover. The characteristics that are noteworthy of an inherited IRA are that: an individual may withdraw funds from an inherited IRA at any time without paying a penalty, owner of an inherited IRA must withdraw it funds and the owner of the inherited IRA may never make contributions to the IRA. When taking these factors into account the Supreme Court held that an inherited IRA is not within the same meaning of “retirement funds” language used in the exemption. So what is the moral of the story? If you receive an inherited IRA you should cash it out immediately and put the money into a Traditional IRA or Roth IRA as soon as possible.