In a recent United States Supreme Court decision, the Court unanimously found that IRAs that are inherited, are not protected from creditors in a bankruptcy proceeding because they are not considered “retirement funds” as interpreted by the Bankruptcy Code.
In the case, CLARK V. RAMEKER, an individual inherited an IRA from her mother and later filed for bankruptcy. At the time she filed for bankruptcy, the IRA had roughly $300,000.00 remaining. Typically, when filing for bankruptcy, certain assets are considered exempt, including retirement funds. However, until this case was decided it was unclear whether an IRA which is inherited receives the same protection as an IRA as an IRA that is still held by the original contributor. To the detriment of the IRA beneficiary, the United States Supreme Court found that inherited IRAs do not have the same protections.
The determining factor was based on legal distinctions between an IRA that one has created on their own and one that is inherited from someone else. IRAs that are funded during lifetime are meant to be used to support the holder during retirement and therefore protection from bankruptcy is justified. However, once an IRA is inherited (both traditional and Roth), the funds are no longer considered retirement assets because inheritors cannot contribute additional funds to the account and can withdraw money from it at any time without penalty.
It is important to distinguish an Inherited IRA from a spousal rollover. When an owner of an IRA dies and names their spouse as a beneficiary, that spouse can rollover the funds into a new IRA and it can be treated as if it was their own. As with the original IRA owner, the spouse must take distributions at age 70 ½ and may take distributions without incurring a penalty as early as 59 ½. By contrast, individuals who inherit IRAs who are not spouses must take out minimum distributions each year based on their life expectancy, starting by December 31 of the year after the IRA holder died, regardless of their age, or withdraw the entire account within five years of the IRA holder’s death.
One way to protect an inheritor from their creditors is to create a trust which can accept retirement assets either in a trust created under the IRA holder’s Will or a free-standing trust. In order to “accept” retirement accounts, the trust typically acts as a “conduit trust” whereby the minimum required distributions of the IRA flow through to the beneficiary, or an “accumulation trust” whereby the required minimum distributions accumulate within the trust and can be used for the beneficiary at the discretion of the Trustee. In either trust design, the oldest beneficiary of the trust would be the measuring life for determining the stretch of the IRA. Because of this rule, it is imperative to have the trusts designed to have the primary beneficiary of the trust be the youngest beneficiary so they are able to get the maximum tax-deferred growth available.
Once an IRA trust is created either under a Will or a standalone trust document, the designated beneficiaries must be changed with the institution holding the IRA. This should only be done with the assistance of a professional since the IRS has specific titling requirements when naming a trust as a beneficiary.
It is well established that designating a trust as the beneficiary of an IRA can be a useful tool for beneficiaries such as minors or disabled individuals who cannot manage their own funds. Now, the decision in CLARK V. RAMEKER has solidified the importance of IRA planning for beneficiaries who may encounter creditor problems.