Protecting Inherited IRAs from Creditors

Who is the beneficiary of your IRA? It’s likely your spouse or children, but you may want to change that in response to a recent United States Supreme Court case. On June 12, 2014, the Supreme Court ruled unanimously that inherited IRAs are not insulated by the same creditor protection in bankruptcy as traditional or Roth IRAs.

To understand the impact of the Clark case, it’s important to know what will happen to your IRA after you die. If you name your spouse as your beneficiary, your spouse may “roll over” the assets into his or her own traditional or Roth IRA or open an “inherited IRA” to hold the assets. If anyone other than your spouse is your beneficiary, he or she does not have the option to “roll over” the assets andmust use an inherited IRA.

Inherited IRAs are subject to a different set of rules than traditional or Roth IRAs. Some of the most important differences are summarized in the table below:

Accepts Contributions? Penalty for Early Withdrawal? When do required distributions begin? Traditional IRA Yes Yes After age 59½ Roth IRA Yes Yes After age 59½ Inherited IRA No No On Receipt

The Bankruptcy Code protects certain very specific assets of debtors from their creditors, including “retirement funds.” The debtor in the Clark v. Rameker case declared bankruptcy and tried to protect the money that her mother left her in an inherited IRA from her creditors using the “retirement funds” exception. Her creditors, of course, wanted the court to force the beneficiary use the funds in her inherited IRA to pay her debts. If the assets were held in a traditional or Roth IRA, they would absolutely be protected under the “retirement funds” exclusion. The Supreme Court was asked to decide whether the same protection kept Clark’s creditors from reaching her inherited IRA. The Court ruled that because of the differences between how a traditional or Roth IRA and an inherited IRA operate, assets in inherited IRAs do not fit the definition of “retirement funds.” Therefore, a debtor’s inherited IRAs are to be treated in the same way as assets held in any other non-retirement account for purposes of the Bankruptcy Code. Essentially, the creditors won.

The creditors won’t always win. With the right planning, you can protect the IRA that you leave to your children in case of a bankruptcy. One way to do this is to create an IRA trust and name the trust the beneficiary of your IRA. Make sure that you consult a knowledgeable attorney to counsel you and, if appropriate, to draft an IRA trust. The IRA trust must be carefully constructed and implemented to obtain the benefit of tax deferral, and also to avoid an unintended distribution of the IRA, which would result in a large tax bill in one year. For more information on any aspect of estate planning or taxation, please contact Timoney Knox, LLP.