Supreme Court: Inherited IRAs Are Not Protected From Creditors

Jackie Bedard
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Attorney, Author, and Founder of Carolina Family Estate Planning

Supreme Court of the United States Ruling: Inherited IRAs Not Protected in Bankruptcy; Use Trusts for Protection

With one unanimous ruling, the Supreme Court on June 12 eliminated asset protection benefits of the Inherited IRA.

In the case of Clark v. Rameker, the Court ruled that an IRA Heidi Heffron-Clark inherited from her deceased mother in 2000 is not eligible for protection from creditors. Heffron-Clark and her husband, Brandon C. Clark, filed for Chapter 7 bankruptcy in 2010 and identified the IRA, which was worth about $300,000, as exempt from the bankruptcy estate.

IRAs are traditionally creditor proof for the creator of the IRA.  In this case, the mother had protection. The key issue for the court to determine was whether that protection passed to her daughter, the beneficiary of the IRA.

9-0 verdict

In writing the unanimous ruling, Justice Sonia Sotomayor said that in practical terms, retirement funds are understood to be money set aside for the day a person stops working. As such, there are legal protections - including the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 -that shield these assets from creditors in a bankruptcy case so that the money is there for a person's retirement.

But three legal characteristics of inherited IRAs give proof that they do not hold retirement funds. 

First, Sotomayor wrote, the IRA inheritor never is allowed to invest additional funds into the account. Second, holders of inherited IRAs must withdraw money from the account regardless of how far they are from retirement. Third, the inheritor can withdraw money from the IRA - including the entire balance - at any time and use it for any purpose. 

The ruling, says The Wall Street Journal, applies only to IRAs but not to other types of retirement accounts such as railroad pensions.

In general, a non-spousal IRA heir must withdraw the full account within five years of the initial owner's death or take out minimum amounts each year starting by December 31 of the year after the IRA owner died, Forbes says. And that's true whether it's a traditional IRA or a Roth IRA.

If you want to protect it, use a trust!

The best way to protect a non-spousal IRA inheritor is to leave the funds to a trust.

There are multiple strategies to use around trusts. However, to drive this point home, consider if Heffron-Clark's mother had planned ahead and used a trust - it would have protected the entire $300,000!

Naturally, the type of trust your client should use will vary depending on how many beneficiaries, the tax goals, assets protection goals, as well as many other variables.  

The case also opens up a really interesting opportunity for marketing to clients with retirement plans.  If they have ANY concerns about creditors and divorce protection for their children, exploring setting up a trust is a great way of opening up a conversation as an advisor. Plus, it can be a great tax deferral strategy for the beneficiary. The payments coming out of the IRA can be tied to the inheritor's life expectancy, which supports tax deferral and a nice income stream. Combined with protection, in the case of bankruptcy or divorce, a trust can make a lot of sense. 

One crucial thing to keep in mind: the IRA's beneficiary should be the trust itself and not the inheritor.

Spousal benefits

The Court's ruling only applies in non-spousal IRA cases. Surviving spouses have an option that isn't available to other inheritors because the survivor is permitted to roll the assets into his own IRA. In this way, he can postpone distributions until he turns 70½ , but he'll still have to pay a 10 percent penalty if he takes the money out before turning 59½.   

If the surviving spouse does not do the rollover, the account is considered an inherited IRA. The survivor wouldn't have to withdraw any money until the decedent would have turned 70½, but with the Court's ruling, Forbes says, those assets don't seem to be protected in a bankruptcy.Investment News also notes that in many states, a spousal rollover by a debtor could be considered a fraudulent conversion of non-exempt assets, which would lose protection for that money.

To learn more about common estate planning issues, check out our free guide, Estate Planning Pitfalls: The 12 Most Common Threats to Your Estate & Your Family's Future, or to discuss your estate planning concerns, please call our office at 919-443-3035 or use our contact form.​