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85 YEAR OLD OPENING A ROTH IRA
Question: “A friends’ mother (85 years old) is thinking about opening a ROTH IRA and investing in a note.
What should we be aware of?”
Other than the standard due diligence on any investment, the key concern here is making sure that your friend’s mother has compensation type of income (generally, the type of income you pay Social Security and Medicare tax on) at least in the amount of the contribution, and no more than the maximum income limits ($117,000 for a full contribution for a single individual, with a partial contribution allowed with up to $132,000 of Modified Adjusted Gross Income, or MAGI, or $184,000 for a full contribution for a married couple filing jointly, with a partial contribution allowed with up to $194,000 of MAGI). If she is married filing jointly with her spouse, he can make the income as long as they file taxes jointly and do not make over the income limits.
A couple of other things come to mind. First, I would not spend every dime she has on a note unless you are really sure it will work out. If the Roth IRA owns the note and it goes into default, the Roth IRA must pay any foreclosure costs. Also, even though she will never have to take any Required Minimum Distributions (RMDs) from her Roth IRA, her beneficiaries will have to take RMDs, unless she leaves it to her spouse who assumes the account as his own. So depending on who she leaves the account to, she may want to leave enough cash in the account to cover any anticipated RMDs.
As a side issue, this looks to be a great opportunity to set up a Roth IRA which is to be inherited by a younger person. Once the Roth IRA is seasoned, the person who inherits the account can take tax free distributions for the rest of their life, regardless of his or her age. Therefore she will want to do some careful consideration to who she wants to leave this precious asset to upon her demise. I know no one likes to think about their own mortality, but to fail to plan is to plan to fail. Personally I would rather leave this earth with a smile on my face knowing I have done everything possible to keep the government’s grubby hands off of my hard earned wealth!
I’m not sure if that’s what you were looking for, but that’s my $0.02 worth. Have a great day, and good luck with your investments!
CONTRIBUTIONS AND EARNED INCOME
“My son, Daniel, opened up a Roth IRA December 2015 and had interest earnings in January 2016 thru April 2016. In the meantime he was working on his 2015 taxes and is using filing status of married filing separately. We found out he is ineligible to contribute to a Roth because he earned over $10,000. However he is eligible to contribute the full amount to a traditional IRA since he has no employer retirement plan.
Can we open up a traditional Ira account and recharacterize his original $5000 contribution? However, how should Daniel handle the interest he earned between January 2016 and April 18, 2016. It will total approximately $259 once he gets his April interest payment posted. When he is doing his taxes using turbotax, it does not allow him to recharacterize more than the original Roth IRA contribution. He could list his original contribution as $5259 instead of $5000 since he is still under the $5500 maximum.
What do you recommend? Christopher won’t file his 2015 taxes until we find out the proper thing to do.
Last but not least, after this is straightened out, we would like to roll the traditional back to the Roth account and pay the taxes due.”
First let me remind you that neither I nor Quest IRA, Inc. can provide you with tax, legal or investment advice, only education which you need to confirm with your own tax advisor.
Your son may certainly open a traditional IRA up and recharacterize his contribution from the Roth IRA to the traditional IRA. When doing a recharacterization, the net income attributable (NIA) must also come over to the traditional IRA. In this case the calculation is easy, if that’s all the money he had in the account (if I understand your fact scenario correctly). I cannot answer why Turbotax will not allow the recharacterization of the full amount, so you will need to address that issue with them. His 5498 will reflect a contribution of $5,000, so that needs to match. He will receive a 1099-R for 2016 reflecting his recharacterization into the traditional IRA for the full amount. Obviously the IRS understands their own rules regarding NIA, so this should not be a problem.
Finally, he should be able to convert the traditional back into the Roth IRA, but he must wait at least thirty days to do so from the date of recharacterization.
If you have any further questions, please do not hesitate to contact us. Have a great day!
PRECIOUS METALS IN A QUEST IRA
How are you? A couple months ago I was inquiring about a self directed IRA and home storage for gold. I was looking back through email, but did not find an answer. I think we might have spoken, but I do remember that Quest did not support home storage in an IRA. One question I still have is if not home storage, how does Quest store and manage gold in a self directed IRA. Also, if you don’t mind, what are the caveats associated with home storage? I have another service I investigated that is still pushing their home storage option. Thank-you for your time and assistance.
In the past we have simply used one of the gold depositories. There are a number of them that store physical gold for custodians. However, it always was a tiny part of our business.
In general Internal Revenue Code Section 408(m)(3)(B) contains the exception to the general rule that investments in collectibles, including any metals, is treated as a distribution from the account (see IRC 408(m)(1)). The exception applies ‘if such bullion is in the PHYSICAL POSSESSION of a trustee…’ (emphasis added). I assume, and I may be wrong, that the ‘home storage companies’ (for lack of a better term) have you open some type of LLC or other entity of which you are the manager, and argue that your IRA’s investment is therefore not in metals directly but rather in the shares of an LLC that owns metals. They believe this gets around the statutory requirements for the physical possession of the metals to the in the name of the trustee or custodian.
As you have noted, we have found it administratively infeasible to hold investments in the way that we understand the home storage companies propose. Neither Quest IRA, Inc. nor I may provide you with tax, legal or investment advice in this or any other area. In a self-directed IRA of any type, it is up to you to make the determination of whether or not the proposed investment is acceptable for an IRA. If you decide to go down this path, then you should look carefully at the documents to satisfy yourself that their method passes IRS scrutiny. Perhaps they even have a ruling that you can look at to help you feel more confident.
I wish you the best of luck, and I’m sorry I can’t be of any further assistance to you at this time.
UBIT ON ASSIGNMENT FEES
In the attached article you discuss assignment fees within an IRA. Client is a HomeVestors franchisee in the business of real estate. Do you think doing a contract assignment within a Solo 401(k) would be subject to UBIT? I’m worried that his status of being in the business of real estate could subject his other activities to taxation.
You didn’t attach the article, but you’re right the whole assignment issue, or even buy, fix and flip, is lot trickier for Homevestor franchisees and other real estate dealers. The easiest way to think about when UBIT attaches is to think of how that income would be taxed if reported outside of the IRA or 401(k) context. For a Homevestor franchisee it’s pretty easy to see where the problem might be, since a house is merely inventory to be sold to its customers in the ordinary course of business- the very definition of Unrelated Business Income in this context. Another potential challenge for a client like that is that there could be an excess contribution or even a prohibited transaction issue (the PT issue because of possibly providing services to their plans) when they are using their company’s resources to find the deals they invest in. Generally you have a better argument that it was purely an investment if a different Homevestor franchisee happens to find the deal if they will invest through their retirement account. Added to this is the fact that a 401(k) plan has a much higher chance of audit and caution is warranted in the investment selection within a Homevestor franchisee’s plan. I did have one real estate dealer who got his plan audited a few years ago and although they let him get away with some flipping in his plan they did charge him for some UBIT. In this case and many others the old adage that piglets get fed but hogs get slaughtered applies – you may get away with some such activity, but the more you do, especially if that’s your only type of investment activity, and the more money you have for the auditor to be jealous of, the more chance you have for a negative result of some sort. That’s the best I can do for a Sunday afternoon. I hope it makes some sense. There are times when it’s a lot more fun to only provide education as opposed to scary things like tax, legal or investment advice!
BACK DOOR ROTH CONVERSION
I am Quest IRA client since 2012 and have a question for you regarding a recent (Dec 2015) IRA contribution and subsequent Roth conversion. My initial strategy was to make a non-deductible IRA contribution and immediately convert to my Roth IRA since my income level does not allow me to contribute directly to a Roth IRA. As I am looking into this further, I think my understanding was flawed. Since I have a traditional IRA (say all traditional IRA’s combined = $500K before $5,500 contribution), the IRS will view this recent conversion to Roth as taxable on a prorata basis ($5,500 of the $505,500)…so only. about $60 of the conversion to Roth will be considered non-taxable. If I am now understanding correctly, what are my options for recharacterzing back to traditional IRA?
Also, I’d like to understand your views on traditional vs Roth IRA and if / when it makes sense to convert to Roth. Are you available for direct consultation?
Your understanding is correct. After tax basis in all your traditional IRAs combined comes out of the traditional IRA distribution on a pro rata basis. You may recharacterize the Roth conversion back into a traditional IRA up until your tax filing deadline including extensions, so if you change your mind you can still reverse the 2015 Roth conversion.
Although I am more than happy to provide you with excellent education, neither I nor Quest IRA, Inc. can provide you with tax, legal or investment advice regarding your IRA. However, your question is timely, since I am teaching our class this evening on Roth conversions. Although you may not be able to attend the class in person, our classes may all be viewed live by Periscope. You can even ask questions that will be answered. If you need help with how to get set up to view the class, feel free to reach out to Rebecca Miller in our Austin office or any of our IRA Specialists.
ROTH GUIDELINES FOR MY INVESTMENT
If my PPT options a note with the intent of finding another buyer, how much if any earnest $$ does the PPT have to put down to be in compliance with the ROTH guidelines? The ROTH is not keeping the tale of the note. I assume the same pertains for a real estate transaction.
Thanks for the question. Unfortunately, there is no good answer.
I would be a little concerned with your verbiage below, however. You state that you want your PPT to option a note “with the intent of finding another buyer.” That sounds definitively like note brokerage, as opposed to a great investment. Note brokerage is a service, which would normally be subject to self-employment taxes outside of the context of an IRA. If so, then it is a service inside of an IRA as well, meaning there is the dual risk of it being called Unrelated Business Income (UBI), which as you know is taxable to your IRA, or worse a prohibited transaction because you are providing services to your IRA.
This reminds me of the bankruptcy case in Atlanta, Georgia earlier this year (Cherwenka v. RES-GA Gold, LLC). In that case a house flipper was accused of entering into a prohibited transaction by providing ‘services’ to his IRA. Fortunately, the house flipper won in bankruptcy court and preserved his IRA. He argued successfully that all he did is make investment decisions. Unfortunately, it is not a Tax Court case, so it doesn’t have as much impact as we would like. It does frame the argument nicely, though, so it is definitely worth reading. I’m not at all sure the case would have turned out the same way in Tax Court. It will be interesting to see if the IRS picks up on this argument in future cases.
The important point is that you are permitted to make great investments in your IRA. You are not permitted to provide services to your IRA or make an excess contribution to your IRA, whether that be in the form of services or manipulating the paperwork to get a grossly undervalued asset into your account, especially from related parties. The Tax Court has the power to look at the substance of a transaction over the form of documentation used. You must always structure any transactions in your account as investments. For this reason I generally encourage people to stay in the deal in some way, because in that way it is more easily understood to be an investment.
Of course this is fun to talk about from an academic viewpoint, but in the real world you must be practical. Look at risk vs. reward. Remember that piglets get fed, but hogs get slaughtered. The size of your IRA and the nature of your transactions will influence what the IRS position might be in the unlikely event of an audit.
I’m sorry there isn’t a clearer answer to your question. As you know, Quest IRA cannot provide you with tax, legal or investment advice. I’ve tried to give you some things to think about, but you should definitely check with knowledgeable tax and/or legal counsel before entering into any type of investment.
ROTH CONVERSIONS AND THEIR 5 YEAR CLOCK
“I converted $18,000 in a traditional IRA to a Roth IRA in 1998. I also made $20,000 in contributions over the years 1998-2010. Last year I took a distribution of $38,000. I am under age 59 1/2.
Do I have any taxes or penalty on this withdraw?”
No, as you describe the situation. Regular contributions come out first, followed by Roth conversions, and finally profits. The rules for calculating any taxable amounts from a Roth IRA distribution are described in IRS Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs). The explanation begins on page 30. You can access this information by clicking on the link below:
As you will see, you will need to attach some tax forms to your return to claim this exemption. If you’re not sure how to complete the forms, the assistance of a tax professional may be advisable.
There are plenty of articles on the web which explain the rules. Many tax preparers get very confused because there are two different 5 year clocks which apply to Roth IRAs. One is the qualified distribution clock, which requires you to have a Roth established somewhere for your benefit at least 5 years prior to the distribution for it to be qualified, and additionally you have to be 1) over 59 ½, or 2) totally and permanently disabled; or 3) dead and the distribution is to your heirs; or 4) you are taking no more than $10,000 for a first time home purchase. A qualified distribution is one on which there is no penalty and no taxes. Once you are into qualified distributions, the 5 year conversion clock becomes wholly irrelevant.
The second 5 year clock, which applies in your case, is the Roth conversion clock, and it is used to determine whether or not you owe a 10% premature distribution penalty if you are under 59 1/2 and don’t meet any of the other exceptions. This conversion clock has nothing whatsoever to do with taxation of the distribution, it only has to do with the 10% premature distribution penalty.
As you already know, Roth distributions come out of the account in a certain order, which is:
1) Regular contributions;
2) Taxable Roth conversion contributions;
3) Non-taxable Roth conversion contributions; and
4) Profits on all contributions.
In the first three categories, the taxes have already been paid on the money, so there is no tax due and it is only a question of the penalty. If you get into the profits and it is not a qualified distribution, then taxes are owed on that portion. So how are the penalties figured? Your regular Roth contributions are never taxed or penalized upon withdrawal, even if you are under 59 ½ and meet no other exception. Once you go past your regular Roth contributions you have to figure out whether a penalty applies, again assuming you do not meet one of the other exceptions to the penalty.
With taxable Roth conversion contributions, which appears to be what you are describing in your email, the penalty will apply if you withdraw the money within 5 tax years of the conversion. After this, no penalty applies. In your case, if you converted in 1998, no penalty should apply because it has been in your Roth IRA for more than 5 tax years, even though you are under age 59 ½. Each Roth conversion has its own 5 year clock, and the conversion withdrawals are taken on a first in, first out basis.
The purpose of the 5 year conversion clock is to prevent abuse of the rules. For example, I am under 59 ½ (although some days I don’t feel that way!). If I do a Roth conversion, of course I pay taxes on the conversion but no penalty. If the 5 year conversion clock were not in place, I could simply withdraw the money from the Roth IRA and avoid the 10% premature distribution penalty entirely. The rule was put in place to prevent this from occurring. It forces you to recapture the 10% penalty you would pay if the money was still in the traditional IRA.
Hopefully that helps clarify where this is coming from. I find often that understanding the background of a rule makes what is otherwise confusing a little more clear. I do think that if your tax preparer follows through on the calculations in Publication 590-B that should resolve any doubts
UBIT? YOU BET!
I think the answer to my question. Does Arkansas charge tax on UBIT and UDFI?
in the book 2009 Multistate Guide to Regulation and Taxation of Nonprofits By Steven D. Simpson. Which is found in full online through google books at:
It says that Arkansas does not have IRS code sections 501-529, but that it does tax unrelated business income on income attributable to Arkansas. Since UDFI is Section 514 I assume that there is no state income tax on UDFI. I also believe that attributable to Arkansas means the source of the income is physically inside the state.
This book seems to be a source of answers on UDFI and UBIT for all 50 states or at least a starting place.
I still have the following 3 questions from yesterday in a more simplified form:
1) If you pay UDFI on the sale of a depreciated rental property do you also recapture depreciation at a 25% rate?
2) If my IRA purchases a condo for nightly rental using debt will it owe UBIT on the nightly rental and UDFI on the profit percentage of the debt?
3) In the following published article you state that UDFI is on Acquisition debt. Does this infer that if I pay cash for the house and then borrow against it later there is no UDFI? In other words is UDFI on all debt or just aquisition debt.
Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its
disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.
Thanks for the reference and the questions yesterday. Sorry we couldn’t get to all of them on the call. As far as your questions:
1) I believe the IRA would owe this tax, but I have heard different arguments on this. If you think about it, it wouldn’t make sense to be able to deduct depreciation from current UDFI and then escape it on the sale of the property. However, one CPA told me that if the property had been paid off for more than 12 months so there was no capital gains tax then there wouldn’t be depreciation recapture either. I think this was based on the theory that ‘depreciation recapture’ is really another form of capital gains, technically called ‘unrecaptured section 1250 gains.’ To be honest, I just don’t know.
2) That’s a good question. Certainly running a hotel is considered to be a business operation as opposed to just rental income, so I see where you could assume that the nightly rentals would be UBI and not UDFI. I think that if it is considered to be a business operation then probably all income from that business would be UBI not UDFI. I don’t think you can split the capital gains in that case away and call them UDFI, but once again I’m really not that confident, especially this early in the morning. On the other hand, if it were me I would probably just report it as UDFI and see if the IRS disagreed. There is a lot of ambiguity in this area, unfortunately.
3) Another good question, but this one I can actually help you with. Acquisition indebtedness is 1) when acquring or improving the property; 2) before acquring or improving the property if the debt would not have been incurred except for the acquisition or improvement; or 3) after acquiring or improving the property if (a) the debt would not have been incurred except for the acquisition or improvement, and b) incurring the debt was reasonably forseeable when the property was acquired or improved. So most likely in your scenario the debt would still be considered ‘acquisition indebtedness.’
Here is an interesting brain twister: what if my IRA owns a piece of land with no debt which produces no income but which is expected to be sold within a year. If my IRA borrows money to purchase bank stock, which will not be sold for several years, which property is considered debt-financed, the land or the bank stock? If the answer is the bank stock, then can my IRA escape taxation entirely on the gains from the bank stock because the debt will have been paid off from the sales proceeds of the land for more than 12 months prior to the sale of the bank stock?
COVERDELL ESA & PARTNERING ACCOUNTS
“Quincy: RE: A Coverdell ESA, if an individual has contributeed to a Coverdel on behalf of his child for the last 3 years, $2,000 each yerar for a total of $6,000, can he withdraw the $6000 in contributions, leaving the accumlated gains? If so are there any tax related consequences?
2nd question: can my ROTH and HSA partner to buy or option a note and share in the profits. Or can say the ROTH buy option and sell to the other IRA to derive a profit.”
Regarding the Coverdell ESA distribution, go to IRS Publication 970, entitled “Tax Benefits for Education,” which you can download for free from www.irs.gov. The description of how to calculate the taxability of distributions is on page 53. Essentially, the distribution is done on a pro rata basis. In other words, normally each distribution will contain part of your after-tax contributions and part of any gains made in the account. Unlike the Roth IRA, your basis is not distributed first. In addition to taxes, a 10% penalty would be owed for any portion of the distribution which is taxable because it exceeded the Adjusted Qualified Education Expenses (AQEE). To the extent there was sufficient AQEE, there is no tax and no penalty on the distribution.
As to your second question, partnering your Roth IRA and your HSA is the same as partnering two IRAs – they are disqualified persons to each other, so you cannot invest in any way where one benefits disproportionately. Arguably they could partner with each other on equal terms, although you will want to be cautious in how you handle the investment if you go that route. The most conservative answer is to not partner disqualified persons together at all. However, many people choose to partner accounts together, even if they are disqualified persons too each other.
SELLER FINANCED REAL ESTATE
“Hey Quincy – wife and I met you on IRA Fun Cruise in January. This is a rookie question. Sceanario: we buy an investment property through one of our Roth self directed IRAs. We plan on putting 20K down and getting seller financing for the balance of purchase price. The property is tenant occupied with a Property Manager in place. The property is currently in a land trust and I believe seller wants to use a land contract of sale to sell to our IRA. #1, is that type fo sale to us considered “non-recourse”? #2, from the purchaser perspective, what is your opinion on buying property through a land contract of sale? Thanks so much.”
That is a great question. Whether the debt instrument is a land contract or a deed of trust or a mortgage, it has to be made clear that the only thing the lender can do is take the property back from your IRA. There would need to be language in the land contract (generally just a short paragraph) making this clear. As to your second question, in some states that is a very common way to sell property, while in other states such as Texas it is fairly rare. You would need to get some local advice on that issue, unfortunately.
The only other thing that comes to mind is that this may cause your IRA to owe Unrelated Business Income Tax (UBIT) on the profits from this property. I just finished recording a webinar on this topic with Matt Allen of North American Savings Bank (www.iralending.com) which should be up on the website soon. Also, we have a more extensive webinar that we have recorded on this subject which you can find on our website, as well as written materials. I wasn’t sure how well versed you were with the rules for debt-financed property within an IRA.
FLIPPING REAL ESTATE OPTIONS IN AN SDIRA
Quincy Long said in the following article* that you can flip real estate options in a SD-IRA. Can this be done multiple times per year without being classified as a “dealer” ? Because it’s options and not physical real estate would the “dealer” status not apply ?
Also, if the option flipping is done frequently, would I incur UBIT because I’m carrying on an “active business” ?
Are there ways to avoid UBIT and still do multiple option flips in a SD-IRA ?
You ask some very good questions in your email about flipping options. The key to understanding the rules for self-directed IRAs is to always remember that an IRA is intended to be for investment purposes only. People make the mistake all the time of trying to effectively run a business using their personal services for the benefit of their IRA, which is a prohibited transaction. The Tax Court has given the IRS a win in a number of cases where people have done this.
IRS Publication 598 may be of some assistance in answering your questions about Unrelated Business Income Tax as it applies to options. According to Publication 598, “Unrelated business income is the income from a trade or business regularly conducted by an exempt organization and not substantially related to the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity.” So the question as it pertains to options is whether or not the activity would be considered a ‘trade or business’ which is ‘regularly conducted.’ One way of determining how the IRS might view this is to ask your CPA how he would report the income on your personal income tax return if it was done outside of the IRA. If his answer is that it would be reported on Schedule C, then it almost certainly will cause the IRA to owe UBIT, and may cause even more problems, depending on the circumstances.
Specifically on options, IRS Publication 598 states (on page 10), when speaking of exclusions from UBI, “Lapse or termination of options. Any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable income. The exclusion applies only if the option is written in connection with the exempt organization’s investment activities. Therefore, this exclusion is not available if the organization is engaged in the trade or business of writing options or the options are held by the organization as inventory or for sale to customers in the ordinary course of a trade or business.” [emphasis added] While not precisely speaking about real estate options, it is pretty clear that if you trade options at a level where they would be considered as inventory for sale to customers in the ordinary course of a trade or business it will cause the IRA to owe taxes. This is analogous to a flipper of real estate. Think of the company who ‘buys ugly houses.’ To a franchisee of that organization, a house is just inventory, because they are a real estate dealer. I think if you trade too many real estate options you could land in the same situation as a real estate flipper.
So how many options can you do? How much can you do before you are providing ‘services’ to your IRA in violation of the prohibited transaction rules, as opposed to merely making investment decisions? These are questions that cannot be answered with certainty. The best guideline I can provide you with is to make sure all of your IRA transactions are structured and treated as investments, and not the resale of inventory. Purchasing and selling an option on real estate once is most likely not a business activity, and you are not likely to be considered to be providing a service to your IRA other than investment selection. Do that same transaction 25 times in the same year in the same account and it changes character. Where the line is I cannot tell you. Remember also that you can self-direct a traditional IRA, a Roth IRA, a SEP IRA, a SIMPLE IRA, an individual 401(k), an HSA, and a Coverdell Education Savings Account (CESA). You may have multiple accounts for you and your family. Unless you are very active, in general you should have no problems with having your IRA become a dealer in options.
The best advice is to have a mix of different types of investments in your IRA. If you hit a home run on some of them then that’s great for your retirement. Good luck with your investments!
U. S. SUPREME COURT RULES THAT INHERITED IRAS ARE NOT PROTECTED IN BANKRUPTCY
On June 12, 2014, the United States Supreme Court ruled in a unanimous opinion that inherited Roth and traditional IRAs are not protected from creditors under the “retirement funds” exemption in the U.S. Bankruptcy Code. The case is Clark v. Rameker, Trustee, 573 U.S. ____ (2014).
In 2001, Heidi Heffron-Clark inherited a traditional IRA worth approximately $450,000 from her mother, Ruth Heffron. Ms. Heffron-Clark elected to take monthly distributions from the account. In 2010, Ms. Heffron-Clark and her husband Brandon Clark filed Chapter 7 bankruptcy and identified the inherited IRA, then worth approximately $300,000, as exempt under Bankruptcy Code Section 522(b)(3)(C). The bankruptcy trustee and unsecured creditors objected to the exemption on the ground that funds in an inherited IRA were not “retirement funds” within the meaning of the statute. The Bankruptcy Court agreed, and disallowed the exemption. The Clarks appealed to the District Court, which reversed the decision of the Bankruptcy Court. Undeterred, the bankruptcy trustee Rameker appealed to the 7th Circuit Court of Appeals, which reversed the District Court and ruled that the inherited IRA was not exempt. The 7th Circuit Court expressly disagreed with the 5th Circuit’s ruling in In Re Chilton, 674 F.3d 486 (2012), which ruled in favor of the debtor’s exemption of an inherited IRA. The U.S. Supreme Court decided to hear the case to resolve the conflict between the Circuit Courts.
When an individual debtor files bankruptcy, his assets become part of the bankruptcy estate. However, the Bankruptcy Code allows debtors to exempt from the bankruptcy estate some limited property. The exemption in this case allows debtors to protect “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code” (see Sections 522(b)(3)(C) for state exemptions and 522(d)(12) for federal exemptions) . Traditional IRAs are created under Internal Revenue Code (IRC) Section 408, and Roth IRAs are created under IRC 408A.
The Supreme Court ruled that the ordinary meaning of “retirement funds” is properly understood to be sums of money set aside for the day an individual stops working. According to Justice Sotomayor, who wrote the unanimous opinion for the Court, there are three legal characteristics of inherited IRAs which provide objective evidence that they do not contain such funds: 1) the holder of an inherited IRA may never contribute additional money to the account; 2) holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement; and 3) the holder of an inherited IRA may withdraw the entire balance of the account at any time, and use the money for any purpose, without penalty. This interpretation is said to be consistent with the purpose of the Bankruptcy Code’s exemption provisions, which effectuate a careful balance between the creditor’s interest in recovering assets and the debtor’s interest in protecting essential needs. Nothing about an inherited IRA’s characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for purposes of current consumption. The court was not persuaded by the Clarks’ claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for that purpose.
So what are the implications of this ruling for those who inherit traditional or Roth IRAs? If the inheritor of an IRA is a spouse who is under age 59 ½, they would normally want to leave the IRA as a beneficiary (inherited) IRA rather than roll the IRA into their own account. As long as the funds are being distributed from an inherited IRA there is no 10% premature distribution penalty, and the spouse would not be required to withdraw money from the IRA until their deceased spouse would have reached age 70 ½. This gives the surviving spouse access to money in the inherited IRA which they may need. However, now an inherited IRA will not be protected in bankruptcy in most cases, so a spouse who is in financial difficulty may decide to roll the inherited IRA into their own IRA where at least it will have creditor protection.
If a non-spouse beneficiary inherits an IRA, it cannot be rolled into their own IRA and must either be distributed entirely by the end of the 5th year following the year of death or over the inheritor’s expected lifetime. If the IRA is inherited directly by the non-spouse beneficiary, there will be no way in many cases to protect that IRA in bankruptcy. One solution that some planners have proposed is the leave the IRA to a properly drafted spendthrift trust rather than to the beneficiary directly. Having the IRA inherited by a properly drawn spendthrift trust can prevent the IRA funds from going to the beneficiary’s creditors. This ruling may be a boon to estate planning attorneys.
The news is not all bad, however. Some states, such as Texas and Florida, specifically protect inherited IRAs from creditors. Debtors who live in these states will have their inherited IRAs protected from creditors outside of the bankruptcy context and even in bankruptcy (assuming they meet the residency requirements) if they choose to use the state exemptions instead of the federal exemptions. However, a person with a large IRA should not automatically assume that the IRA would be protected even if they and their children live in a state with creditor protection for inherited IRAs. The state exemptions apply to the residence of the debtors, not to the residence of the deceased person, and people move around a lot. Life happens. Where your beneficiaries live now may not be where they live after inheriting your IRA. Unexpected events occur, and you must plan for them.
One thing is certain – estate planning for those with beneficiaries who are struggling with financial issues has become even more important. Also, bankruptcy planning for anyone who has a large inherited IRA just got more complex.
For a more complete analysis of the Clark v. Rameker case see the blog post of Texas bankruptcy attorney Steve Sather at http://stevesathersbankruptcynews.blogspot.com/2014/06/supreme-court-denies-exemption-for.html. You may read the Supreme Court’s opinion at http://www.supremecourt.gov/opinions/13pdf/13-299_mjn0.pdf.
Nothing in this article is intended as tax, legal or investment advice. If you need assistance with estate or bankruptcy planning, you should consult with a competent professional who practices law in these areas.