Bankruptcy, Inherited IRA, and Excess Contributions-Oh My!

Take-Away: If a retirement account, e.g., an IRA, is not tax-exempt under the federal Tax Code, it is not protected under the federal Bankruptcy Code. This can all happen if there is an excess contribution to the IRA.

Background: From past missives, we know that while IRAs are protected when the IRA owner files for bankruptcy [Bankruptcy Code Section 522(d)(12), we also know that inherited IRAs are not protected in bankruptcy because, other than a surviving spouse, the inherited IRA cannot be treated as the beneficiary’s own for bankruptcy protection purposes [Clark v. Rameker,573 U.S.  2014, where the Supreme Court held than an inherited IRA is not a ‘retirement fund’ within the meaning of the Bankruptcy Code.] These rules were at play in a recent federal bankruptcy and District Court decision with an interesting set of facts.

Farber v. Feldman, U.S. District Court of Pennsylvania

Facts: Paula filed for Chapter 7 Bankruptcy in August 2021. Paula claimed that her Allianz IRA annuity was an exempt IRA. The Bankruptcy Trustee objected to that claim. Paula’s father had died in December 2017, leaving her an interest in a Prudential ‘product.’ Paula claims that she was unsure of the type of the Prudential account that she inherited. Paula received a check from Prudential in the amount of $41,000. Paula used that inherited amount to open a new IRA in her own name at Wells Fargo, which Paula later then rolled over to open a new traditional IRA annuity with Allianz in 2018 with an initial amount of $41,447.

In the Bankruptcy proceedings Paula initially admitted that the IRA was inherited, but she later changed her position to claim that while it was not a trustee-to-trustee transfer, it was a valid rollover of ‘her’ funds which she used to establish her own IRA, which existed two years before she filed for bankruptcy. Consequently, Paula’s position was that the inherited IRA ceased to exist in 2018 and the ‘new’ IRA that she funded was a qualified was with her own funds that was an exempt asset in Bankruptcy. The Trustee filed an Objection to Paula’s claim of IRA exemption.

Bankruptcy Court: The Bankruptcy Court sustained the Trustee’s Objection. Paula appealed to the federal District Court.

District Court: Paula both won, and she lost, in the federal District Court, in something of a ‘rollercoaster’ decision.

Paula Wins! -Inherited IRA: The District Court judge found that the Trustee bore the burden to prove by a preponderance of evidence that Paula’s claimed IRA exemption was improper, since a claimed exemption is presumptively valid in bankruptcy. The judge found that based on Paula’s testimony that she used the Prudential funds inherited from her father  to open a new IRA in her own name at Wells Fargo, she was not seeking to exempt an inherited IRA, which is contrary to law (see Rameker), but her own traditional IRA, which was presumably exempt under the federal Bankruptcy Code.  Paula prevailed on this point before the judge,  but that was not the end of the judge’s inquiry.

Paula Loses- It’s Not a Valid IRA: The Bankruptcy Trustee’s fallback argument was that Paula’s own IRA to which the funds were ultimately transferred at Wells Fargo, was not a qualified, tax-exempt, IRA because it was funded with an amount that far exceeded the maximum annual contribution limit. Under IRC 408(a)(1) and (b)(2)(B) an important requirement for a valid IRA is that contributions to the IRA, other than rollovers, must not exceed the annual limit described in IRC 219(b)(a)(A). In 2018, for Paula who was then age 52, that dollar limit was $6,500, inclusive of catch-up contributions. Paula funded her initial Wells Fargo account with $41,000+ from the Prudential proceeds. Accordingly, Paula could not have started her own ‘new’ IRA with a contribution of $41,000+.

The judge found that Paula’s contribution was ‘well in excess of the maximum premium amount allowable in 2018.” Accordingly, because the Wells Fargo IRA was invalid from its inception due to the excess contribution to it, Paula’s subsequent rollover from that account to her Allianz IRA annuity did not ‘cure’ that defect. The judge noted that Paula’s rollover “did nothing to render any of the funds in that annuity validly exempt from taxation, or from her bankruptcy estate.”

Paula Wins-No Excise Tax: The consequence of an excess contribution to a traditional IRA is the imposition of an excise tax. That tax/penalty imposes a 6% annual excise tax on the amount of the excess contribution.[IRC 4973(a)(3).] This rule precludes the tax-exempt status of Paula’s account beyond the $6,500 limit. Thus, because the funds contributed by Paula in excess of the yearly limit are not exempt from taxation and they cannot be exempted under the Bankruptcy Code. In addition, because Paula’s account contained a significant excess contribution that gave rise to tax liability, the IRA itself was not a “fund or account that is exempt from taxation” which is required for bankruptcy protection. By definition then, Paula’s current IRA is not tax exempt, and the over-funding is a ‘prohibited transaction, as a form of self-dealing. [IRC 4975(c).]

However, the judge found that Paula’s only alleged wrongdoing was contributing too much money to her own IRA, which did not fall within the specific definitions of prohibited transactions listed in IRC 4975. Accordingly, the judge agreed with the finding that Paula did not engage in a prohibited transaction that would otherwise have triggered the 6% excise tax on the excess contribution to her IRA annuity at Allianz.

Conclusion: Some final thoughts about inherited IRAs.

The Temptation with Inherited IRAs: Paula inherited a non-spousal IRA that she could not simply withdraw from, and deposit the money into a new, self-titled IRA to avoid the Clark v. Remeker holding. That will not protect the inherited IRA in bankruptcy,  if that deposit contravenes the existing IRA contribution limits. While the federal judge ultimately found that Paula’s account was not an inherited IRA, her attempt to create a new personal IRA using those inherited funds failed for reasons due to Tax Code’s IRA contribution limits. Mixing inherited IRA funds with one’s own IRA funds is a temptation many inheritors mistakenly succumb to.

Not All IRAs are Tax-Exempt: Just because funds are held in a traditional IRA or Roth IRA does not automatically guarantee its tax-exempt status or that its protection in bankruptcy will prevail. IRC 408 has statutory requirements that must be met. If those requirements are not met, then it is not a tax-exempt, valid, IRA that is entitled to tax deferral or bankruptcy protection.

Beware Excess Contributions: Funding an IRA with an amount that exceeds the annual limit under IRC 219 can render the entire account non-exempt in bankruptcy, and not just the excess portion. The resulting 6% excise tax under IRC 4973 is evidence that the funds are not fully tax-exempt.

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