Compliance June 13, 2014

SCOTUS Rules Inherited IRAs Not Exempt in Bankruptcy

The Supreme Court of the United States (SCOTUS) upheld a lower court’s determination that inherited individual retirement accounts (IRAs) do not share the same bankruptcy protections as self-funded IRAs.
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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.

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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.

In Practice June 13, 2014

When Financial Blows Make Clients Feel They Can’t Save

Divorce, and other financial blows, can mean a sticky conversation for advisers when clients say they just can’t save for retirement.
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It’s common for people to feel squeezed during or after a divorce, says Adam Nugent, president of Foresight Wealth Management. They can be facing child support and alimony payments, and possibly they have lost half their assets, or half the household income, through a split. But the feeling of loss is a perception, he tells PLANADVISER. It’s a more visible bill to pay, but the same money was spent before the divorce, and likely in similar ways.

Nugent says there are ways to keep saving for retirement when finances change. “Analyze spending in other areas to see if they can save for retirement,” he says. “A lot of times, you can go through an analysis of everyone’s finances and find that there is money to save.”

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People often have memberships to gyms that aren’t being used. Common places to cut back are phone bills, going to restaurants and the daily Starbucks habit, which can be as much as $6 or $7 a day, Nugent says.

Advisers can help individuals take a hard look at their budgets to trim the fat. “We can make recommendations on saving on car or home insurance or refinance a mortgage,” Nugent says, noting that sometimes he runs through the budget and finds a client spending more than he has.

Some people are simply unwilling to save when their financial situation changes suddenly, Nugent says, “and nothing I say is going to change someone’s thinking,” he says “Emotionally, sometimes people are not in a position to save.” Younger people in particular find it easy to relegate saving for retirement to the backburner, something they say they’ll get to eventually. 

This mindset is unacceptable to Jason Chepenik, managing principal of Chepenik Financial, who takes a much harder line. He admits it is a hard conversation, but he feels clients sometimes have to be forced. “Even if it’s a reduced amount, you have to continue saving,” he tells PLANADVISER.

Drop, Don’t Stop

People may need to be taught that it is preferable to drop the amount they save than give up saving altogether, Chepenik says. Dropping the amount, from 10% to 2% or 3%, will make a difference. He counsels clients that one day things will improve. He suggests they try visualizing their lives a few years ahead, when economically things get back to a more normal state. There is nothing wrong with temporarily reducing savings because of an economic change, he says.

Chepenik uses the term RAIDS—recently acquired income deficiency syndrome—to describe the state of abruptly changed finances. All these obligations can seem like a sudden attack, he says. It is common for people to wonder where the money is going to come from.

Another concept Chepenik says he likes to teach is, “Ten percent is yours to keep.” People work so hard, he observes, and most people spend more years working than they do in school or in retirement. He thinks of retirement as a reward for all those years of working hard—and it is well deserved. “Why shouldn’t you be rewarded for all this work you do? Ten percent of what you earn is yours to keep.” He admits there are times when it is not possible to make that 10% savings, but anything a person saves can make a difference.

One of Chepenik’s favorite quotes is from the prizefighter Mike Tyson: “Everybody has a plan until they get hit in the face.” Divorce is a punch in the face, Chepenik says. He takes a philosophical perspective on this life crisis. “Shut your eyes, and three, four years will pass quickly, and you’ll find your footing and begin again,” he says.

Habits are made from behaviors that you repeat and repeat and repeat, Chepenik points out. “That’s the beauty of saving,” he says. “You don’t want to lose that habit. Always saving is vitally important for your future and for your family. “

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