Inherited IRAs in Texas & Creditors’ Rights
by Karen Suhre and Cecil A. Ray Jr.
When creditors’ rights, bankruptcy law and retirement plan tax rules collide, confusion often ensues. Recently, that occurred when creditors claimed recovery from debtors’ “inherited IRAs.”
Individual Retirement Accounts (IRAs) are trusts or custodial accounts with financial institutions which comply with Internal Revenue Code (IRC) requirements governing operation, investments, distributions and contributions. IRAs were added to the IRC in 1974 by the Employee Retirement Income Security Act (ERISA). Several types of IRAs have evolved over time, each with special features too complex to detail here, but undistributed investment earnings in all types of IRAs are exempt from current federal income tax.
At the IRA owner’s death, any remaining funds pass to the owner’s beneficiaries. Like other types of tax-advantaged retirement plans, IRAs are intended primarily to provide retirement payments to the owner and his or her spouse, and only incidentally payments to beneficiaries. In most cases, tax penalties encourage the IRA owner not to take withdrawals until after age 59-1/2, and minimum required distribution (MRD) rules limit the deferral of withdrawals after 70-1/2 and/or death.
The IRC has long allowed a beneficiary who is the surviving spouse to elect to treat funds in the decedent’s IRA, or rollovers from certain employer sponsored plans, as the spouse’s own IRA (with MRD commencement and tax penalties keyed to the spouse's age and additional contributions by the spouse allowed). A non-spouse can also be the beneficiary of an IRA (and, starting in 2007, may be able to “rollover” benefits from certain employer-sponsored retirement plans into an “inherited IRA”) but does not have the option to treat the IRA as his own retirement account, often resulting in payout commencing before the beneficiary’s retirement age. Although IRAs can be “inherited” by a spouse or others, the IRC confusingly defines “inherited IRAs” to exclude IRAs “inherited” by a spouse.
Patterson v. Shumate, 504 U.S. 753 (1992), held that ERISA exempts many employer-sponsored retirement plans from creditors’ claims in bankruptcy cases, but most IRAs are not covered by that provision of ERISA. In Texas, self-settled retirement accounts, including “Keogh” plans and most IRAs, failed to obtain protection as “spendthrift trusts” under Texas trust law. To protect the retirement savings of Texas residents, in 1987, IRAs and certain other tax-favored retirement accounts were designated as exempt property by Section 42.0021 of the Texas Property Code. In 2005, Section 42.0021 was amended to expand the classes of exempt IRAs to include “Roth IRAs” among other things, but no specific reference was made to “inherited IRAs.”
A comprehensive exemption for IRAs and certain other tax-favored retirement accounts is also found in Sections 522(b)(3)(C) and 522(d)(12) of the Bankruptcy Code, as amended in 2005, exempting “retirement funds” in “a fund or account that is exempt from taxation” under various enumerated provisions of federal tax law, including IRC Sections 408 and 408A, the operative tax exemption provisions for “regular” and Roth IRAs, respectively. However, the 2005 Bankruptcy Code amendments, like the Texas Property Code, did not explicitly refer to “inherited IRAs.”
Around the beginning of this century, creditors began to challenge the exemption of “inherited IRAs” in Texas and other states with fair success, particularly focusing on the more limited tax benefits given to IRAs inherited by non-spouse beneficiaries as a rationale for denying the exemption. By 2010, at least two bankruptcy courts in Texas had ruled that such inherited IRAs were not exempt property.
The battle to save inherited IRAs from creditors in Texas proceeded on two fronts. In 2011, the Texas legislature amended Section 42.0021 of the Texas Property Code to add an explicit reference to “inherited IRAs” to the list of exempt retirement accounts, and to clarify that other exempt retirement accounts received by reason of death continue to be exempt. In the meantime, a Texas bankruptcy case involving an IRA inherited from the debtor’s mother worked its way up to the Fifth Circuit. In Re Chilton, 674 F. 3d 486 (5th Cir. 2012) held that “inherited IRAs” were exempt under Bankruptcy Code Section 522(d)(12), reasoning that “retirement funds” set aside in an IRA for the benefit of a decedent did not lose their “retirement” character even when passed to a non-spouse beneficiary, and that investment earnings in an inherited IRA remain exempt from taxation under IRC Section 408.
For now, inherited IRAs appear to be safe from creditors in Texas, so long as the accounts continue to comply with applicable tax requirements.