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CCH® PENSION — 04/20/12

Inherited IRA was exempt from debtors’ bankruptcy estate

In a case of first impression, the U.S. Court of Appeals at New Orleans (CA-5) ruled that funds in an inherited IRA were exempt from the bankruptcy estate of the debtors under Bankruptcy Code Sec. 522(d)(12).

Prior to filing for bankruptcy, one of the debtors inherited an IRA from her mother. The debtor established an IRA to receive the funds from her mother's IRA and the funds were directly transferred to the inherited IRA. Thereafter, the debtors filed for bankruptcy under Chapter 7 of the Bankruptcy Code. The case was later converted to Chapter 13 of the Bankruptcy Code. The debtors claimed the inherited IRA as exempt from their creditors under Bankruptcy Code Sec. 522(d)(12). The bankruptcy trustee objected to the claimed exemption. The U.S. bankruptcy court, in a 2010 decision, sustained the trustee’s objection. However, the federal district court reversed, citing a number of cases decided subsequent to the bankruptcy court’s ruling that arrived at the opposite result. This appeal ensued.

Section 522(d)(12) allows an exemption for retirement funds in an account or fund that is exempt from taxation under Sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code. Thus, the exemption claimed must satisfy two requirements: (1) the amount that the debtor seeks to exempt must constitute retirement funds and (2) those funds must be in an account that is exempt from tax under Code Secs. 401, 403, 408, 408A, 414, 457, or 501(a). The issue on appeal was whether inherited IRAs satisfy these two requirements of Bankruptcy Code Sec. 522(d)(12), a case of first impression for the circuit courts.

Retirement funds

As to the first issue, the court noted that the phrase "retirement funds" is not defined in the Bankruptcy Code. However, the court observed, most of the courts that have analyzed this issue have concluded that inherited IRAs are retirement funds. These courts have noted that the bankruptcy statute does not explicitly limit "retirement funds" to funds that belong to the debtor. Accordingly, the courts have reasoned that "retirement funds" can include the funds that others had originally set aside for their retirement, as with inherited IRAs. The defining characteristic of "retirement funds" is the purpose they are "set apart" for, not what happens after they are set apart, the court said. Here, the funds contained in the debtor’s inherited IRA were "set apart" when the debtor’s mother deposited them in an IRA. Thus, the funds contained in the inherited IRA constituted retirement funds under the bankruptcy statute, the court held.

Grounds for exemption

Since the transfer of the mother’s IRA to an inherited IRA had already occurred at the time the debtors filed for bankruptcy, the court noted, the dispositive issue was which Code provision rendered the inherited IRA exempt from taxation subsequent to the transfer. The expansive language of Code Sec. 408(e) ("[a]ny individual retirement account is exempt from taxation under this subsection …") indicates that Code Sec. 408 is the exempting section for all IRAs, the court held.

While inherited IRAs operate differently from traditional IRAs, the definition of "individual retirement account" in the Code encompasses inherited IRAs. Accordingly, said the court, after an inherited IRA is established, it stands to reason that distributions from the inherited IRA are subject to the same provision as all other IRAs--that is, Code Sec. 408--for the purpose of determining whether they are exempt from taxation. Because Code Sec. 408 is one of the sections specified in Bankruptcy Code 522(d)(12), inherited IRAs are contained in an "account" that is "exempt from taxation" as that phrase is used in the bankruptcy law.

Since both requirements of section 522(d)(12) of the Bankruptcy Code were satisfied, the court affirmed the district court’s opinion and held that the inherited IRAs were exempt from the bankruptcy estate.

Source: In the Matter of Chilton (CA-5).

For more information, visit http://www.wolterskluwerlb.com/rbcs.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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