A recent decision from the U.S. District Court for the Eastern District of Pennsylvania, Farber v. Feldman, offers a critical analysis of the requirements for exempting Individual Retirement Accounts (IRAs) from a bankruptcy estate under 11 U.S.C. § 522(d)(12). The case highlights the intersection of bankruptcy law and the Internal Revenue Code (IRC), particularly concerning the consequences of funding an IRA with amounts exceeding the annual contribution limits prescribed by IRC § 219(b)(1)(A). This article examines the court’s detailed analysis and its implications for advising clients on the proper handling of retirement funds, especially those originating from an inheritance.

Factual and Procedural Background

The debtor, Stephanie Paula Farber, filed for Chapter 7 bankruptcy on August 3, 2021, and sought to exempt an IRA held with Allianz, an annuity company. The Bankruptcy Trustee, Lynn Feldman, objected to this exemption, alleging the IRA was inherited and therefore not eligible for exemption.

The central facts revolve around the origin of the funds in the debtor’s Allianz IRA. In December 2017, the debtor’s father passed away, leaving her an interest in an account at Prudential Life Insurance. The debtor testified she was unsure of the account type at Prudential but received a check for approximately $41,000. She used these funds to open a new IRA in her own name at Wells Fargo, which she later rolled over to establish the traditional IRA annuity with Allianz on April 13, 2018, with an initial amount of $41,447.

The debtor initially admitted the IRA was inherited but later changed her position, arguing that she did not perform a trustee-to-trustee transfer of an inherited IRA. Instead, she claimed she withdrew the funds via a rollover and used them to establish her own personal IRA for her retirement, which existed for over two years before her bankruptcy filing. She contended that because the inherited IRA "ceased to exist in 2018," the new IRA she formed was a qualified, exempt asset.

The Bankruptcy Court sustained the Trustee’s objection, and the debtor appealed to the District Court.

Legal Framework for IRA Exemption in Bankruptcy

The court’s analysis began with the bankruptcy exemption itself. Under 11 U.S.C. § 522(d)(12), a debtor may exempt "Retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under... 26 U.S.C. § 401, 403, 408, 408A, 414, 457, or 501(a)". The core of the dispute, therefore, was whether the debtor’s Allianz IRA was an account "exempt from taxation" under the IRC.

The Trustee bore the burden of proving by a preponderance of the evidence that the claimed exemption was improper. A claimed exemption is considered presumptively valid, and the objecting party must produce evidence to rebut that presumption.

The Court’s Analysis of Inherited vs. Self-Funded IRAs

The court first addressed the established principle regarding inherited IRAs. Both parties and the court agreed that an IRA inherited from anyone other than a deceased spouse cannot be treated as the beneficiary’s own for exemption purposes under 11 U.S.C. § 522(d)(12). This aligns with the Supreme Court’s ruling in Clark v. Rameker, 573 U.S. 122 (2014), which held that inherited IRAs are not "retirement funds" within the meaning of the bankruptcy exemption. The Supreme Court identified three key characteristics of inherited IRAs that distinguish them from traditional IRAs:

The holder cannot make additional contributions.
The holder must take required minimum distributions regardless of their age.
The holder can withdraw the entire balance at any time for any reason without penalty.

Based on the debtor’s testimony that she used funds from Prudential to open a new IRA in her own name at Wells Fargo, the bankruptcy judge found that she was not seeking to exempt a traditional inherited IRA. The District Court affirmed this finding. However, this conclusion did not end the inquiry; it shifted the focus to the validity of the Wells Fargo IRA created by the debtor.

The Problem of Excess Contributions

The Trustee’s primary argument, and the one the court found persuasive, was that the debtor’s IRA was not a qualified, tax-exempt account because it was funded with an amount far exceeding the maximum annual contribution limit.

Under IRC § 408(a)(1) and § 408(b)(2)(B), a key requirement for a valid IRA (whether a trust or an annuity) is that contributions, other than rollovers, must not exceed the annual limit established by IRC § 219(b)(1)(A). In 2018, for a taxpayer of the debtor’s age (52), this limit was $6,500, inclusive of catch-up contributions. The debtor admittedly funded the initial Wells Fargo account with approximately $41,000 from the Prudential proceeds.

The Trustee’s expert witness, a CPA, testified that the debtor could not have started a new IRA with $41,000. The court accepted this expert testimony, finding that the debtor’s contribution was "well in excess of the maximum premium amount allowable in 2018".

The court concluded that because the Wells Fargo IRA was invalid from its inception due to the excess contribution, the subsequent rollover to the Allianz IRA annuity did not cure this defect. The rollover "did nothing to render any of the funds in that annuity validly exempt from taxation or from her bankruptcy estate".

Tax Consequences and Exemption Status

The court further examined the tax consequences of an excess contribution under the IRC. It noted that IRC § 4973(a)(3) imposes a 6% annual excise tax on the amount of excess contributions to an individual’s IRA. This tax liability, according to the court, "precluded the tax-exempt status of the account beyond the $6,500.00 limit".

Citing supporting case law, the court reasoned that because the funds contributed in excess of the yearly limit are not exempt from taxation, they cannot be exempted under 11 U.S.C. § 522(d)(12). Therefore, because the debtor’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" as required for bankruptcy protection. "By definition then, the Debtor’s current IRA is not tax exempt," the court held.

Inapplicability of the Prohibited Transaction Rules

The Trustee also argued that the excess contribution constituted a "prohibited transaction" under IRC § 408(e)(2)(A), which would disqualify the account from tax-exempt status. This section states that if an individual engages in a transaction prohibited by IRC § 4975, the account ceases to be an IRA. Prohibited transactions under IRC § 4975(c) include actions such as self-dealing by a fiduciary or the transfer of plan assets for the benefit of a disqualified person.

The bankruptcy judge, however, found that the debtor’s only alleged wrongdoing was contributing too much money to her own account, which did not fall under the specific definitions of prohibited transactions listed in IRC § 4975. The District Court agreed with this finding, concluding that the debtor did not engage in a prohibited transaction.

Conclusion and Key Takeaways for Practitioners

The District Court affirmed the Bankruptcy Court’s order, upholding the disallowance of the debtor’s claimed exemption for the Allianz IRA. The decision reinforces several critical points for tax professionals:

Form Matters: Simply titling an account as an "IRA" does not guarantee its tax-exempt status or its protection in bankruptcy. The account must meet all statutory requirements under IRC § 408, including strict adherence to contribution limits.
Excess Contributions Can Be Fatal to Exemption: Funding an IRA with an amount exceeding the annual limit under IRC § 219 can render the entire account non-exempt in a bankruptcy proceeding, not just the excess portion. The resulting 6% excise tax under IRC § 4973 is evidence that the funds are not fully tax-exempt.
"Cleansing" Inherited Funds: Clients who inherit non-spousal retirement funds cannot simply withdraw the money and deposit it into a new, self-titled IRA to circumvent the Clark v. Rameker ruling if the deposit violates contribution limits. While the court found the account was not an "inherited IRA," the attempt to create a new personal IRA with inherited funds failed for other reasons related to IRC compliance.

This case serves as a reminder of the importance of advising clients on the precise rules governing IRA contributions and rollovers. A misstep, such as making an excess contribution, can have devastating consequences, potentially exposing what was intended to be protected retirement savings to creditors in bankruptcy.

Prepared with assistance from NotebookLM.