Probate and Trust Article

June, 2007

INHERITED IRA NOT PROTECTED FROM CREDITORS

By

Jim Roberts

Glast, Phillips & Murray, P.C.

Dallas, Texas

Federal law provides protection for most qualified plans, including 401(k), pension and profit sharing plans.But protections for Individual Retirement Accounts (“IRAs”) are a matter of state law. Most, if not all, states provide that IRAs are exempt. But there is a growing body of case law questioning the exemption of inherited IRAs.

A recent case highlights this growing trend. In Re: Russell Jarboe d/b/a RJ’s Brokerage & Plants 1(cite) was a case out of the United States Bankruptcy Court for the Southern District of Texas, Houston Division. It interpreted Texas law and, in particular, § 42.0021 of the Texas Property Code. In general, subsection (a) of that provision exempted from seizure by creditors those assets, whether vested or not, in “any stock bonus, pension, profit sharing, or similar plan, including a retirement plan for self-employed individuals, and under any annuity or similar contract purchased with assets distributed from that type of plan, and under any retirement annuity or account described in Section 403(b) or Section 408A of the Internal Revenue Code of 1986, and under any Individual Retirement Account or any Individual Retirement Annuity, including a simplified employee pension plan, and under any health savings account described in Section 223 of the Internal Revenue Code of 1986, is exempt from attachment, execution, and seizure for the satisfaction of debts unless the plan, contract or account does not qualify under the applicable provisions of the Internal Revenue Code of 1986.”

While Texas law was at issue, many states have similar types of provisions. For example, New York law, in Article 52, § 5205(c)(2), exempts “all trusts, custodial accounts, annuities, insurance contracts, monies, assets or interests established as part of, and any payment from, either any trust or plan, which is qualified as an Individual Retirement Account under Section 408 or Section 408A of the United States Internal Code of 1986, as amended …”. Florida law, in Title XV, Chapter 222, Section 222.21(2)(a)(2) exempts any money “maintained in accordance with a plan or governing instrument that has been determined by the Internal Revenue Service to be exempt from taxation under s.401(a), s.403(a), s.403(b), s.408, s.408A, s.409, s.414, s. 457(b), or s.501(a) of the Internal Revenue Code of 1986, as amended …”.

In this Texas case, the Court noted that the statutes of the different states, while all having an apparently similar purpose, are different in their wording. And thus, while citing other cases from other jurisdictions, the Court concluded that none of those cases provided anything more than food for thought. In this case, the statute contained trailing language behind the primary operative provision, and referred to plans that are “qualified” under the Internal Revenue Code. The Court asked the question, “What does this mean?” The Court cited cases from other Bankruptcy courts, all of which have opened the door for creditors to seize inherited IRAs. One case was In re Kirchen. 2(cite) The Kirchen court listed what it perceived to be the attributes of an IRA, concluding that if an IRA does not satisfy those requirements, it “will not qualify or comply with the Internal Revenue Code.” 3(cite) Using Kirchen as a guide, the Court in the Texas case focused on the following: (a) the IRA could not be rolled over into another IRA (as the original participant or a beneficiary-spouse might be able to do); (b) contributions could not be made to the inherited IRA; (c) most importantly, the owner of an inherited IRA could remove funds from the IRA at any time, for any reason, and without penalty; and (d) the person inheriting the IRA was required either to start taking lifespan-measured withdrawals from the IRA within one year or to take the entire amount within five years, regardless of the beneficiary’s age. The one thing the Court conceded that inherited IRAs have in common with other IRAs is tax deferral.

As a result of these key differences, the Court concluded “… that an IRA inherited from someone other than a spouse may not be claimed as exempt …”. And, as a result “… an inherited IRA does not ‘qualify’ under Texas Property Code § 42.0021. The mere fact of temporary tax deferral is insufficient.” And, thus, the creditors were allowed to reach the assets inside the inherited IRA.

One of the trends advocated by some recently is that all people should have “inheritance trusts,” and that such trusts should be the designated beneficiaries of their parents’ and others’ wills, life insurance and retirement accounts. Perhaps such a trust, with an IRA-sensitive tax provision, interposed between the decedent-participant and the beneficiary-debtor, could be a possible means to alleviate this growing problem. But, then, whether that will work when what otherwise appeared to be the plain language of a statute did not, is something that should be carefully considered and questioned.

1. 2007 Bankr. LEXIS 1147

2. 344 B.R. 908 (Bankr. E.D. Wisc. 2006)

3. 344 B.R. at 913.