Last Thursday, the United States Supreme Court ruled in Clark v. Rameker that funds held in inherited individual retirement accounts (IRAs) are not “retirement funds” for bankruptcy purposes.

In October 2010, the Clarks filed for bankruptcy and claimed that Heidi Clark’s $300,000 inherited IRA was exempt from their bankruptcy estate under Section 522 of the Bankruptcy Code (which provides that tax-exempt retirement funds are exempt from a bankruptcy estate). The bankruptcy trustee and creditors objected to this, taking the position that the funds were not “retirement funds” within the meaning of Section 522. The Bankruptcy Court agreed with the trustee and creditors.

The district court ruled that inherited IRAs are exempt because they retain their character as retirement funds, but the US Court of Appeals for the Seventh Circuit reversed that ruling. The Supreme Court agreed with the Seventh Circuit, holding that the funds in an inherited IRA are not set aside for the debtor’s retirement and, thus, are not “retirement funds” under the exemption in Section 522.

Driving the Court’s decision is the fact that “[i]nherited IRAs do not operate like ordinary IRAs.” First, in contrast to traditional IRAs, which impose a ten percent penalty on funds withdrawn before age 59 ½, individuals may withdraw funds from an inherited IRA at any time without paying a penalty. What is more, the owner of an inherited IRA must either withdraw the entire account balance within five years of the original owner’s death or take annual minimum distributions. Finally, unlike a traditional or Roth IRA—where the whole purpose of the account is to provide tax incentives to the owner for making contributions—the owner of an inherited IRA may never add funds to an inherited IRA.

Justice Sonia Sotomayor, writing the opinion, 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.”

The Clark decision highlights an important estate planning tool that many individuals and attorneys often overlook: the IRA trust. Briefly, an IRA trust (sometimes referred to as a “conduit trust”) is a trust that has special—very technical—provisions that allow the trustee of the trust to manage the IRA for the benefit of the beneficiary, while at the same time preserve the ability to “stretch” the tax-deferred growth of the IRA over the life expectancy of the individual beneficiary. In this regard, the tax advantages associated with naming an individual directly as the beneficiary of the IRA are combined with the advantages of leaving a gift in trust, which includes (among other things) the ability to shield the assets of the trust from a beneficiary’s creditors—even in bankruptcy.

If you would like to discuss how your retirement benefits fit into your estate plan, or see whether your existing trust qualifies as a conduit trust, please contact one of the experienced estate planning attorneys at Weintraub Tobin.