An “inherited IRA” is an individual retirement account (“IRA”) that is left to a beneficiary upon the IRA owner’s death. If the IRA owner started receiving required minimum distributions (RMDs) at the time of his or her death, the beneficiary must continue to receive distributions from the inherited IRA in an amount equal to the the IRA owner’s RMD or in a newly calculated amount based on the beneficiary’s life expectancy. If, at the time of their death, the IRA owner had yet to choose an RMD schedule or had not reached 70.5 years in age, the beneficiary must withdraw the IRA funds over the following five years, thereby accelerating the associated income tax liability. A spouse who receives an inherited IRA can choose to roll it over into his or her existing IRA accounts with no penalties. This option does not exist for non-spouse beneficiaries.
Under federal bankruptcy law, retirement funds are generally exempt from the claims of creditors in bankruptcy proceedings. Last year, however, in Clark v. Rameker, 134 S. Ct. 2242, 189 L. Ed. 2d 157 (2014), the United States Supreme Court held an inherited IRA does not fall within the definition of “retirement funds” under 11 U.S.C. § 522(b)(3), and therefore, is not exempt from creditors’ claims in bankruptcy proceedings. Clark involved an IRA inherited by a Wisconsin debtor and the ruling made the inherited IRA available to the debtor’s creditors in bankruptcy proceedings.
On February 25, 2015, In re Andolino, 525 B.R. 588 (Bankr. D.N.J. 2015), the U.S. Bankruptcy Court for the District of New Jersey issued a decision under similar facts. Christopher Andolino inherited an IRA worth $120,000 from his mother. He later filed for Chapter 13 bankruptcy, and claimed the inherited IRA was not available to his creditors in the bankruptcy proceedings. The bankruptcy trustee objected, asserting the inherited IRA was property of the bankruptcy estate because, under the Supreme Court’s decision in Clark, inherited IRAs are not exempt from creditors’ claims.
In his decision, Bankruptcy Judge Michael Kaplan noted that while Clark established the rule that inherited IRAs are not “retirement funds” within the meaning of 11 U.S.C. § 522 and therefore not exempt from creditors’ claims, Clark did not establish whether an inherited IRA is property of the bankruptcy estate in the first place. Rather, state law governs this issue. Thus, a determination as to whether an inherited IRA is property of a debtor’s bankruptcy estate under the relevant state law must be made before considering whether an exemption under 11 U.S.C. § 522 applies.
Judge Kaplan referred to N.J.S.A. § 25:2-1(b), the applicable New Jersey statute, which provides protection to any “qualifying trust”, including an IRA, from the claims of creditors and excludes such a trust from the bankruptcy estate. See also In re Yuhas, 104 F.3d 612 (3rd Cir. 1997) (an IRA created and owned by a New Jersey debtor is excluded from the bankruptcy estate because the statute restricts the transferability of the account). The New Jersey statutory provision, however, does not explicitly limit protection to traditional IRAs. Therefore the court had to determine whether the statute could also apply to inherited IRAs.
Judge Kaplan held the New Jersey protective statute applied to an IRA even after the death of the original owner. A “qualifying trust”, he reasoned, included any IRA subject to the provisions of I.R.C. § 408. Although different from the restrictions on traditional IRAs, in normal circumstances an inherited IRA remained subject to a set of “unique tax implications and restrictions”, even after the death of the original owner. Accordingly, the protections under N.J.S.A. § 25:2-1(b) applied to inherited IRAs and excluded inherited IRAs from the beneficiary’s bankruptcy estate; therefore, the issue of whether an exemption from creditors’ claims under Clark and 11 U.S.C. § 522 applied was moot.
Planning Tip: Not every state has the same robust creditor protection for traditional IRAs (and now inherited IRAs) as New Jersey. Individuals who wish to provide creditor protection for beneficiaries living outside of New Jersey may want to consider establishing a New Jersey trust for the benefit of out-of-state beneficiaries and designate that trust, rather than the individual, as the death beneficiary of the IRA. The bankruptcy laws of the state where the trust is located (New Jersey) will govern, rather than the laws of the beneficiary’s domicile.
Daniel L. Mellor is an associate with the firm. He earned his J.D. at the George Mason University School of Law in Arlington, VA and his Master of Laws (LL.M.) in Taxation from the Temple University Beasley School of Law in Philadelphia, PA. Mr. Mellor’s particular areas of expertise include business transactions, estate planning and probate litigation.