The US Supreme Court recently decided the case of Clark v. Rameker, in which a debtor in bankruptcy held an inherited IRA as an asset. Several Circuit Courts of Appeal around the country had concluded that inherited IRAs were not property of the estate or were not exempt assets under the Bankruptcy Code. Other courts had concluded the opposite. The Supreme Court's decision was based upon the usual characteristics of an IRA which cause it to be exempt or not property of the estate. A debtor who owns in IRA can contribute to the IRA and is not required to take a distribution from the IRA within a certain time period. In addition, the funds in a usual IRA are commonly the debtor's own earnings.
By comparison, an inherited IRA represents funds earned by a third party, and a recipient of an inherited IRA can not contribute additional funds into the IRA, and the inherited IRA must be distributed to the recipient within 5 years of receipt. The Supreme Court concluded that an inherited IRA is just a windfall for the recipient which must make the money in the IRA available to the debtor's creditors. The Court held that an inherited IRA did not share the characteristics of retirement funds that Congress determined should be protected in bankruptcy.
The court did note that spouses inheriting an IRA had additional options which could cause that inherited IRA to be safe from creditors in bankruptcy.
What should a debtor who receives an inherited IRA do prior to filing bankruptcy? First, the debtor should explore reinvesting those funds into an IRA or other ERISA qualified retirement programs. Second, if the amount of the inherited IRA is significant, a debtor may want to explore debt settlement options with his or her creditors instead of filing bankruptcy. Finally, a debtor should consider a spend down of the funds for sensible and reasonable expenses necessary for the debtor and his or her family (home and/or car repair, college expenses, or necessary medical expenses). As with any bankruptcy planning involving inheritances, the owner of the IRA or other assets about to be inherited by a debtor should explore spendthrift trusts for the recipient, since those trusts are not property of the bankruptcy estate.