A New Jersey Bankruptcy Court has ruled that a loophole in the Bankruptcy Code may enable Chapter 7 debtors to exempt inherited IRAs from a bankruptcy estate, seemingly diverging from a 2014 U.S. Supreme Court decision that inherited IRAs were not exempt from bankruptcy.
In its unanimous 2014 ruling, the Supreme Court distinguished inherited IRAs from other IRAs established by an individual for his or her own retirement. Because the beneficiary of an inherited IRA cannot make contributions to that IRA, an inherited IRA does not provide any tax incentives, which is an important purpose of other IRAs. Since the beneficiary of an inherited IRA has different rules for taking distributions than other IRA owners, this also establishes inherited IRAs as different from other IRAs. These differences, the Court reasoned, are enough to disqualify an inherited IRA from qualifying for the federal bankruptcy exemption.
In deciding In re Norris, the New Jersey Bankruptcy Court said the Supreme Court’s decision in Clark v. Rameker was not applicable since the high court only considered whether an inherited IRA constituted “retirement funds” for the purpose of the Bankruptcy Code’s retirement exemption.
In its ruling for the debtor, the Court considered the applicability of Section 541(c)(2), known as the “spendthrift trust exception,” which provides that “a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” New Jersey law provides that any property held in a qualifying trust and distributions from that trust are excluded from the bankruptcy estate, including trusts that qualify under Section 408 of the Internal Revenue Code, which includes IRAs.
The Court then clarified a five-part test to determine whether an IRA is excluded from a bankruptcy estate under Section 541(c)(2):
- The IRA meets the standard of “trust” per Section 541(c)(2);
- The IRA funds constitute a debtor’s “beneficial interest” in the trust;
- The IRA is qualified under Section 408 of the Internal Revenue Code;
- The NJSA provision that property held is exempt from all creditor claims must be a restriction on the transfer of IRA funds; and
- The restriction must be enforceable under nonbankruptcy law.
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