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Are Inherited IRAs Protected from Creditors in Bankruptcy

Insights & Ideas Team •  October 9, 2014 | Your Finances

Imagine this: A mom or dad leaves an Individual Retirement Account (IRA) to his or her adult child as the IRA beneficiary. Years later, that son or daughter runs into financial trouble and files for bankruptcy, thinking that at least the inherited IRA will be off-limits to bankruptcy creditors because it’s a retirement account.

Not anymore.

In a recent opinion that is likely to have far-reaching implications, the U.S. Supreme Court upheld a lower court decision that inherited IRAs are not protected from creditors in bankruptcy proceedings under federal law (Clark vs. Rameker, June 2014). According to the high court, it ceases to be “retirement funds” in the hands of the beneficiary and thus loses the protection afforded to IRAs under Section 522(b)(3)(c) of the Bankruptcy Code.

The Story Behind the Decision

The landmark case began in 2010 when a Wisconsin pizza shop owner, Heidi Heffron-Clark, and her husband filed for bankruptcy protection after their shop closed. The Clarks’ main asset was an IRA that Heidi had inherited from her mother, worth $450,000 at the time of her mother’s death.

In their filing, the Clarks listed the IRA as an exempt asset from bankruptcy using the “retirement funds” exemption. The bankruptcy trustee (Rameker), who wanted to access the funds to pay off the Clarks’ debts, disagreed, and the case worked its way to the Supreme Court.

When Is an IRA Not a Retirement Account?

In analyzing the exemption, the Court defined “retirement funds” to mean “sums of money set aside for the day an individual stops working.” As the Court examined the characteristics of inherited IRAs, they ultimately concluded that they are distinct from other retirement accounts in three notable ways.

  • First, beneficiaries cannot add money to an inherited IRA for retirement.
  • Second, they generally must take required minimum distributions (RMDs) from the inherited IRA regardless of how far they are from retirement age.
  • And third, beneficiaries can withdraw additional money beyond RMDs from an inherited IRA at any time and for any purpose without penalty.

Based on these characteristics, the Court concluded that an inherited IRA is not a “retirement fund” and should not be exempt from the claims of creditors in bankruptcy. As Justice Sonia Sotomayor wrote in the Court’s unanimous opinion, “Nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.”

 How to Protect Your IRA Assets

The Supreme Court’s decision has important ramifications for married individuals who inherit an IRA from a spouse. It also will have a significant impact on parents who plan to leave large IRA balances to their children and/or grandchildren in the hopes of extending the tax-deferral benefits of an IRA over many more years.

So what options do IRA owners have to help safeguard their assets now so that any funds their beneficiaries inherit are protected against potential creditors down the road?

While the Court did not specifically address IRAs that are inherited by a spouse, there are special rules under the current tax code that may afford a level of protection, including the ability for a surviving spouse to roll over a decedent’s IRA into his or her own IRA. A rollover would enable the surviving spouse to postpone distributions and continue the tax-deferred growth of the inherited funds until he or she turns 70½. And while the Court did not rule specifically on the impact of a spousal rollover on creditor protection, there’s a decent argument that a rolled-over IRA would seem to have the same level of protection as when it was in the original owner’s hands.

Interestingly, certain states specifically protect inherited IRAs from creditors by having statutes that allow people to opt out of the federal bankruptcy exemptions in favor of their own. If the IRA beneficiary lives in one of these states and files for bankruptcy, he or she should be able to exempt the inherited IRA. The beneficiary also needs to meet domicile requires in order to use the state’s rule; it also assumes that the state law permits a beneficiary to elect a state exemption over the federal exemption.

A more certain way to safeguard IRA assets from creditors, which can be used to benefit a spouse or anyone else, is to name a trust, rather than a person, as the beneficiary of the IRA. An IRA left to an irrevocable trust will have a greater chance of being protected from the claims of the new account owner’s creditors and also from the claims of creditors of the trust beneficiaries.

Using a trust can also provide other important benefits. This includes enabling you to use the oldest beneficiary’s life expectancy to stretch out the tax-deferred growth; control over when you want your beneficiary to receive distributions; the ability to provide for special needs; and a way to protect the asset from future law suits, irresponsible spending and divorce proceedings.

It Pays to Plan

The Supreme Court’s recent ruling underscores the importance of careful planning when it comes to protecting and passing on wealth to loved ones.

For this reason, it may be more important than ever to consult with a wealth management professional with expertise in retirement planning. Proper planning for IRAs and other tax-deferred savings plans is crucial to any sound estate plan. The laws are complicated, and a simple mistake can be costly. An experienced professional can help you understand your options, including the best way to protect your IRA assets so that they’re available to benefit your loved ones for years to come.

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