The Supreme Court ruled nearly a decade ago that self-funded IRAs—i.e., IRAs established and funded by an individual for the exclusive purpose of generating income after retirement—are to be considered exempt assets during bankruptcy proceedings (see “Supreme Court Extends Bankruptcy Protections to IRAs”). The current decision draws a distinction between self-funded and inherited IRAs, ruling that inherited IRAs are not “retirement funds” as defined by Section 522(b)(3)(c) of the U.S. Code, so they cannot be exempted during a bankruptcy.

The ruling in Clark vs. Rameker was reversed several times during the case’s lengthy journey to the Supreme Court, case documents show. The initial bankruptcy court decision drew a similar distinction between self-funded and inherited IRAs, but the ruling was overturned by a district court on the grounds that the bankruptcy exemption covers any account in which the funds were originally accumulated for retirement purposes. The 7th U.S. Circuit Court of Appeals subsequently disagreed and reversed the district court ruling—a decision that has now been approved by the top U.S. court.

The Supreme Court justices were unanimous in their decision to divide self-funded and inherited IRAs for bankruptcy exemption purposes. According to the final opinion written by Justice Sonia Sotomayor, the ordinary meaning of retirement funds is properly understood to be sums of money set aside for the day an individual stops working. Sotomayor points to three legal characteristics of inherited IRAs that “provide objective evidence” that inherited IRAs do not contain such funds—implying they cannot be exempted from bankruptcy-related collections actions.

First, the holder of the inherited IRA may never invest additional money in the account, meaning the account can no longer serve as a vehicle dedicated to long-term retirement savings. Second, holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. Finally, the holder of an inherited IRA may withdraw the entire balance of the account at any time—and use it for any purpose—without incurring the penalties that come along with early distributions from tax-advantaged retirement accounts.

This reading is consistent with the purpose of the Bankruptcy Code’s exemption provisions, Sotomayor writes, which are meant to effectuate a careful balance between the creditor’s interest in recovering assets and the debtor’s interest in protecting essential needs. Allowing debtors to protect funds in traditional and Roth IRAs ensures that debtors will be able to meet their basic needs during their retirement years, Sotomayor explains. By contrast, nothing about an inherited IRA’s legal characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for purposes of current consumption. It is therefore inappropriate to allow such funds to survive a bankruptcy untouched, the top court determined.

Case documents show plaintiff Heidi Heffron-Clark declared Chapter 7 bankruptcy in October 2010. At the time she and her husband claimed the IRA she inherited from her mother—worth about $300,000 on the date of inheritance—qualified as "retirement funds" and should therefore be exempted during subsequent bankruptcy proceedings. However, Heffron-Clark had withdrawn some $150,000 in monthly payouts from the account since her mother's death in 2001, calling into question whether the assets were in fact “for retirement.”

As Sotomayor writes, the retirement-funds exemption should not be read in a manner that would convert the bankruptcy objective of protecting debtors' basic needs into a “free pass.”

The plaintiffs argued without success that the funds in an inherited IRA are retirement funds because, at some point, they were set aside for retirement. But the Supreme Court ruled that their claim conflicts with ordinary usage and would render the term “retirement funds,” as used in Section 522(b)(3)(c), superfluous.

Finally, the possibility that an inherited IRA holder can leave an inherited IRA intact until retirement and take only the required minimum distributions does not mean that such an IRA necessarily bears all the legal characteristics required of true retirement funds, Sotomayor writes.

The full text of the decision, including a summary syllabus, is available here.