During a bankruptcy, retirement accounts are typically exempt property. This means a trustee cannot take them to pay debts owed to creditors. This because they are for use when the debtor retires, Congress decided to exempt those assets from creditors. A recent Chapter 7 case from the Court of Appeals for the Seventh Circuit, however, decided that when an IRA retirement account is inherited, it is no longer a retirement account, and is no longer exempt property under the Bankruptcy Code.

The court found that where a woman inherited an individual retirement account (IRA) from her mother, the character of the asset changed from a retirement account with a tax deferral feature to merely an ordinary asset with limited tax deferral ability. If you create an IRA, you cannot withdraw the money before age 59 ½ or else you pay a tax penalty.

This contrasts with the IRA once it has been inherited. At that point, it must begin distributing its assets within one year of the original owner’s death. And it typically must distribute all of the assets within five years.

The judge noted that while the home of the mother would have been exempt under the bankruptcy code, if the daughter had inherited it and rented it out, it would not have been entitled to the exemption.

This ruling creates a split with decisions from the Fifth and Eight Circuits. This means the Supreme Court may ultimately take the case and decide how an inherited IRA is treated a Bankruptcy

Source: Reuters, “In circuit split, court says inherited IRA fair game in bankruptcy,” Nick Brown, April 24, 2013