Inherited IRAs no Longer Protected from Bankruptcy and Other Creditors
by Jack S. Johal
In the case of Clark v. Rameker (2014) ___U.S.___ [134 S.Ct. 2242, 189 L.Ed.2d 157], the United States Supreme Court ("Supreme Court") ruled that inherited IRAs are not retirement funds and, thus, are not protected from bankruptcy creditors under federal law. This decision is potentially devastating to the millions of Americans that have and will be inheriting trillions of dollars saved by the Baby Boomers over the past decades. While it is clear that creditors in bankruptcy proceedings will now have access to assets that many believed were protected, the extent to which this ruling will enable creditors outside of bankruptcy proceedings to collect on debts and judgments by invading the assets held in an inherited IRA remains unclear.
In Clark, Heidi Heffron-Clark inherited an IRA after her mother passed away in 2001. In 2010, she and her husband filed for bankruptcy and intended to shield the inherited IRA from creditors by counting it as retirement funds. In the past, courts have allowed beneficiaries to do this, but in a stunning and unanimous ruling, the Supreme Court ruled that inherited IRAs are not considered retirement accounts and cannot be shielded during bankruptcy.
In its decision, the Supreme Court asserted that inherited IRAs do not function in the same manner as IRAs that you establish by yourself, and so they should not have the same legal protections. The Supreme Court specifically noted the following three (3) distinguishing factors for not protecting inherited IRAs as retirement accounts:
- Beneficiaries cannot add money to inherited IRAs like IRA owners can to their own accounts;
- Beneficiaries must generally begin to take requirement minimum distributions ("RMDs") in the year after they inherit the account, regardless of when they retire; and
- Beneficiaries can take total distributions of their inherited IRAs at any time and use the funds for any purpose without penalties.
The Supreme Court stated that nothing about an inherited IRA prevents or discourages a beneficiary from using the entire balance immediately after bankruptcy to pay for life's expenses. For these reasons, the Supreme Court held that inherited IRAs are not like normal IRAs and do not function as retirement funds; therefore, they will not be afforded the same protections. For a spouse who does not elect to rollover an inherited IRA or a non-spouse individual, listing an inherited IRA as part of his or her assets and declaring bankruptcy will mean that the inherited IRA is potentially on the table to be liquidated to satisfy creditors just like with any other non-exempt asset in a bankruptcy proceeding. Other non-bankruptcy creditors may also be able to reach the inherited IRA funds. The question for many IRA owners is, "How can I keep my hard-earned money away from my children's (or other beneficiaries') creditors after I'm gone?" The answer is to adjust their estate plans accordingly, because transferring IRAs directly to beneficiaries will no longer be as advantageous as in the past.
Protecting IRAs for Spouse Beneficiaries
Unlike other individuals who inherit IRAs, spouses have the option to rollover the inherited IRA into their own existing retirement account. In the past, surviving spouses often had no reason to rollover, because they could maintain both IRAs and be confident that both would be protected from bankruptcy and other creditors. With the Clark decision, it is far more prudent for spousal beneficiaries to rollover inherited retirement accounts rather than leaving them as separate inherited IRAs. Alternatively, it may be safer and preferable to inherit retirement accounts via a trust. If a trust is drafted properly, certain requirements are met, and the trust contains the appropriate language, it can help shield the trust assets (like inherited IRAs) from trust beneficiary creditors while still allowing the trust to stretch distributions from the inherited IRA over the oldest applicable trust beneficiary's life expectancy.
There are potential downsides, however, to consider when naming a trust as your IRA beneficiary including: (i) increased tax burden due to the compressed trust tax brackets; (ii) ongoing accounting; (iii) trustee fees; and (iv) the precise and complex trust language needed to properly protect the assets. There is little question that a properly drafted trust serving as an IRA beneficiary affords greater creditor and bankruptcy protection for your heirs, but because of the complexity involved, it is critical to seek the advice of an attorney with both estate planning and tax expertise.
Protecting IRAs for Non-Spouse Beneficiaries
Unlike spouse beneficiaries of inherited IRAs, non-spouse beneficiaries do not have the option to rollover the inherited IRA funds into their own retirement or other accounts. Without the possibility to roll over the inherited IRA, other estate planning tools will need to be utilized to protect inherited IRAs from non-spouse beneficiary bankruptcy and creditors. One possible tool, as discussed above, is naming a trust as the beneficiary of an IRA instead of naming an individual. This will ensure that the funds can still be available to your loved ones after you pass away, while retaining their prior protections from bankruptcy and other creditors. As stated above, establishing trusts is a very complex and delicate process, so individuals should seek the advice of estate and tax planning experts.
Clark v. Rameker has changed the rules regarding inherited IRAs, making them a less attractive asset to directly pass on to spouses or children, but it’s important to remember that with rollovers and trusts you can still protect these assets and make them available to your loved ones.
Please contact me if you have any additional questions.
DISCLAIMER: This publication does not constitute legal advice. Readers should consult with their own legal counsel for the most current information and to obtain professional advice before acting on any of the information presented.
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