Last week the U.S. Supreme Court delivered a rare unanimous verdict addressing the status of inherited individual retirement accounts, IRAs, in a bankruptcy situation. The ruling could impact the retirement planning decisions and strategies of employees who work for your clients.

The case, Clark v. Rameker, has its roots in a personal bankruptcy filing of a woman who had inherited an IRA from her mother worth about $450,000 in 2001. The daughter, Heidi Heffron-Clark, promptly began taking monthly distributions from the IRA. By 2010, its value had dropped to $300,000 — the same year she filed for personal bankruptcy.

When creditors wanted to tap into that $300,000 to settle their claims, Clark argued those funds were off limits due to the bankruptcy code’s exemption of “retirement assets” from such claims. However, the bankruptcy court didn’t accept that argument, asserting that funds in an inherited IRA are not retirement assets.

Retirement funds defined

Clark found a more favorable opinion when she appealed the case to the U.S. District Court. But, the U.S. Court of Appeals for the 7th Circuit subsequently shot her down along with the nation’s highest court, which upheld the appellate decision. The Supreme Court defined retirement fund as “sums of money set side for the day an individual stops working.” Clark’s inherited IRA did not square with that definition. Also, the court noted two ways the tax code treats IRAs and inherited IRAs differently, drawing a clear legal distinction:

1. Taxpayers are encouraged, by way of the tax deferral, to put funds into an IRA, whereas owners of inherited IRAs must begin taking distributions within a year of the death of the original holder (assuming the original holder had already begun taking distributions).

2. IRA holders are penalized for withdrawing funds before age 59-1/2, whereas holders of inherited IRAs face no such penalty.

Spousal distinction

In a memo to its clients, lawyers at Washington-based Steptoe & Johnson noted the importance of the distinction between an IRA inherited by a child versus a spouse. “While a spouse who inherits an IRA is initially subject to the inherited IRA rules, the spouse has the right to re-characterize the inherited IRA as his or her own IRA,” the lawyers write. “It may be reasonable to conclude that a spouse’s re-characterized IRA could be excluded from the bankruptcy estate as an exempt ‘retirement fund’ even after” the Supreme Court’s ruling in this case.

When a surviving spouse inherits assets from the deceased’s 401(k) plan, those assets can be re-characterized into an IRA and confer the same tax benefits (and restrictions) as a regular IRA. However, 401(k) assets inherited by someone other than a spouse may fall under the same heading as an inherited IRA. Clients should encourage their employees to consult with a tax attorney when making beneficiary designations for their retirement plans.

Stolz is a freelance writer based in Rockville, Md.

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