Stretch IRA – The Rest of the Story

And Now You Know the Rest of the Story . . .

On November 24, 2010, we posted the blog article, “How Safe Is Your Stretch IRA?”, where we addressed several court cases in which the issue before the court was whether creditors could reach assets held by debtors in stretch IRAs. Well, your stretch IRA just got safer.

As you will recall, a stretch IRA is an individual retirement account that you inherit and then use the stretch-out provisions under the law to take payments over your lifetime (and thus defer the taxes on the distributions over your lifetime).

As we reported on November 24, 2010, several cases, including In re Chilton, had held that an inherited IRA was not entitled to the protections allowed to traditional IRAs under the Bankruptcy Code.

A district court in the Fifth Circuit has now reversed the bankruptcy court’s decision. See here. The district court noted that since the bankruptcy court’s decision, five other courts have all concluded that inherited IRAs do meet the requirements for a Bankruptcy Code exemption.

Agreeing with the reasoning of these other cases, the district court concluded that the funds in a debtor’s inherited IRA do not have to be the “retirement funds” of the debtor to satisfy the bankruptcy exemption requirements. The district court also concluded that inherited IRAs are among the IRAs that are exempt from taxation under § 408(e)(1) of the Internal Revenue Code, which provides that any individual retirement account is exempt from taxation. Because an inherited IRA meets these requirements, any differences between a traditional IRA and an inherited IRA are irrelevant for purposes of the bankruptcy exemption.

How Safe Is Your Stretch IRA?

It is not hard to find reasons to be nervous about the economy and the health of our retirement nest eggs these days. The equity markets continue their multi-year run of historically high volatility, the national unemployment rate only recently dropped into the single digits and the explosion of home foreclosures continues its downward pressure on housing prices.

Another bleak subject in today’s headlines is the record number of U.S. citizens and companies filing for bankruptcy protection. According to a report earlier this month from the Administrative Office of the U.S. Courts, there were over 1.5 million bankruptcy cases filed in the Federal Courts in fiscal year 2010, up over 13% from 2009 (and five times the number of cases reported in 1980)

During a bankruptcy proceeding, the petitioner prepares a schedule of his or her assets and then the court oversees the liquidation of the assets based on the type of bankruptcy filing. Two of the most common types of filings are a Chapter 13, where a petitioner (usually a corporation) agrees to a payment plan that will reimburse creditors for a portion of the money owed them, and a Chapter 7, where the court will discharge an individual’s debt and the person will essentially start a new financial life. During these proceedings, certain assets of the debtor are protected from creditor claims, these are called exempt assets.

It is important to note that in determining the exempt/non-exempt status of assets, the court must look to both federal and state rules. It is the federal rules which outline the bankruptcy proceeding, yet state laws can also come into play when they involve state protective statutes, state trust statutes, real estate statutes, etc. In the case of the Chapter 7 filings, there are some recent state court decisions that throw into question exactly which assets are exempt from the bankruptcy judgment and these cases are illustrative of the measures that creditors are going to in an effort to reach debtors’ assets in these turbulent financial times. This case law, along with different state exemption laws, should give pause to individuals that are inheriting IRAs and planning on utilizing the stretch-out provisions to take payments over their own life expectancy (called the stretch IRA strategy).

The first two cases are In re Chilton (where a Texas bankruptcy court found that inherited IRAs are not entitled to protection) and In re Nessa, where a Minnesota bankruptcy court came to the opposite conclusion. Further, in In re McClelland, an Idaho court allowed for a state exemption to stand, yet courts in California, Oklahoma and Texas (among others) have disallowed these protections. Finally, in Robertson v. Deeb, a Florida court allowed the state exemption to apply, but then ruled that Inherited IRAs were not protected under the Florida rule due to the changes that happen to an IRA (from a tax standpoint) at the moment it is inherited. These cases illustrate the different impact that state statutes – and the strength of individual arguments in these state courthouses – have on the protections available to an individual inheriting one of these accounts.

The case law is largely silent on this issue in Oregon and Washington, however analyzing the statutes suggests that inherited IRAs may be better protected here than in other parts of the country. 

In Oregon, we look to ORS 18.358(e)(2) which says “a beneficiary’s interest in a retirement plan shall be exempt, effective without necessity of claim thereof, from execution and all other process, mesne or final.” This language would seem to exempt inherited IRAs entirely, however it is worth noting that in Robertson v. Deeb the court spent a good deal of time analyzing the statutory language in Fla. Stat. 222.21(a)(2008) to determine exactly what the Florida legislature meant by the word ‘beneficiary’. Under such analysis, ORS 18.358 may leave the door open to creditors attacking inherited IRAs because the statute defines a beneficiary only as, “a person for whom retirement plan benefits are provided and their spouse”. A court may interpret this language to exclude individuals that inherit IRA accounts and, if that is the case, the statutory protections may not apply.

In Washington, the controlling statute offers more protections. RCW 6.15.020 specifically lists IRA (and Roth IRA) accounts as types of ‘employee benefit plans’ and then declares, “The right of a person to a pension, annuity, or retirement allowance or disability allowance, or death benefits, or any optional benefit, or any other right accrued or accruing to any citizen of the state of Washington under any employee benefit plan, and any fund created by such a plan or arrangement, shall be exempt from execution, attachment, garnishment, or seizure by or under any legal process whatever.”

From a planning standpoint, the levels of protection available to these Inherited IRAs are uncertain and under a lot of scrutiny in courtrooms today. On first reading, the Revidsed Code of Washington offers more concrete protections than the language in the Oregon Revised Statutes, however we have now seen courts across the country develop very different interpretations of the federal and state protections allowed to petitioners’ interests in these inherited accounts. The bottom line? One way to shield these assets from claims, regardless of the state you live in, may be to place these inherited assets into a trust. Consult an estate planning attorney to see if this option may be right for you.