Fifth Circuit Finds Inherited IRAs Exempt

In a case of first impression for the Fifth Circuit or any other court of appeals, the Fifth Circuit has ruled that inherited IRA accounts may be claimed as exempt under 11 U.S.C. Sec. 522(d)(12). Matter of Chilton, No. 11-40377 (5th Cir. 3/12/12), which can be found here.

In Chilton, one of the debtors inherited an IRA account in the amount of $170,000. The debtors established an IRA account to receive distributions from the inherited account. The trustee objected that the account was not a "retirement account" and was not the type of tax exempt account identified in section 522(d)(12). The bankruptcy court sustained the objection, but was reversed by the district court.

Section 522(d)(12) allows a debtor who elects federal exemptions (an option available only to debtors in about eleven states since most states have opted out of federal exemptions), to exempt "(r)etirement funds to the extent that such 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 of 1986." Thus, there are two requirements: 1. the funds must be retirement funds and 2. they must be held in an account exempt from taxation under one of the designated sections.

The court rejected the argument that funds set aside for the retirement of another could not be "retirement funds:"

The plain meaning of the statutory language refers to money that was “set apart” for retirement. Thus, the defining characteristic of “retirement funds” is the purpose they are “set apart” for, not what happens after they are “set apart.” Here, there is no question that the funds contained in the debtors’ inherited IRA were “set apart” for retirement at the time Heil deposited them into an IRA. This reasoning finds further support from 11 U.S.C. § 522(b)(4)(C), which provides that “a direct transfer of retirement funds from 1 fund or account that is exempt from taxation under section . . . 408 . . . of the Internal Revenue Code of 1986, . . . shall not cease to qualify for exemption under . . . subsection (d)(12) by reason of such direct transfer.” In other words, the direct transfer of “retirement funds” does not alter their status as “retirement funds.” As we see no reason to interpret the statutory language differently from its plain meaning, we hold that the $170,000 contained in the inherited IRA constitute “retirement funds” as that phrase is used in section 522(d)(12).

Opinion, p. 5.

The Court also ruled that the account was held under the proper section of the Internal Revenue Code. The Trustee argued that the account was tax exempt pursuant to 26 U.S.C. Sec. 402(c)(11)(A), while the Debtor contended that section 408(e) was the relevant section. While this discussion of the Internal Revenue Code would seem arcane and of little interest to bankruptcy lawyers, the Court relied on the expansive language of section 408(e), which stated that "(a)ny individual retirement account is exempt from taxation under this subsection . . . " Because the account was an individual retirement account, it fell within the definition of "any" individual retirement account. Thus, common sense construction carried the day even thought the subject matter was the tax code.

On a final note, the Court of Appeals decided this appeal quite expeditiously. The case was argued on February 22, 2012 and decided on March 12, 2012, just nineteen days later. Judge Carl Stewart should be commended for his prompt work.

Inherited IRA Protected Under Section 522(d)(12)

Joining the majority position, U.S. District Judge Walter Smith has ruled that inherited IRA accounts may be exempted as "retirement funds" under 11 U.S.C. Sec. 522(d)(12). Hill v. Studensky, No. W-11-CA-00214 (W.D. Tex. 2/22/12), which can be found here. (PACER registration required).

The issue on appeal was whether an inherited IRA continued to constitute "retirement funds" once the person for whose retirement they had been saved was no longer alive. The Court found that there were two elements to be satisfied: (1) whether the account contained "retirement funds"; and (2) whether the funds were exempt from taxation.

When an IRA is inherited, the beneficiary may receive the funds immediately, in which case they are recognized as ordinary income. Alternatively, they may be transferred to a new trustee. The account will still be in the name of the decedent and the beneficiary must begin receiving distributions within one year or withdraw the entire amount within five years.

Turning to the issue of whether the inherited IRA constituted "retirement funds," the Court noted that both parties' interpretations were reasonable. However, section (d)(12)'s relation to the other subsections of section 522(d) proved important. The other subsections of section 522(d) referred to the debtor's interest in property, but section 522(d)(12) did not.

The issue of inherited IRAs is presently pending before the Fifth Circuit Court of Appeals. The Eastern District of Texas reached the same result as Judge Smith in Chilton v. Moser, No. 4:10-CV-180 (E.D. Tex. 3/16/11). The case is pending before the Fifth Circuit as Case No. 11-40377, Chilton v. Moser. The case was argued before the panel on February 8, 2012.