Are inherited IRAs protected from bankruptcy creditors?
Earlier this month, the U.S. Supreme Court said no. (Clark v.
So IRA owners may want to reconsider their beneficiary
designations. Despite the added cost and complexity, leaving your
IRA to a trust can be a safe move.
To grasp the issue, consider a hypothetical Art Young, who has
a sizable IRA. If Young files for bankruptcy, that account likely
will be beyond creditors' reach.
"The bankruptcy act of 2005 said that
are protected from creditors," said Ed Slott, an IRA expert in
Rockville Centre, N.Y.
Bankruptcy filers are allowed to keep certain assets to meet
basic needs and make it less likely they'll need public
Now suppose that Young dies after naming his son Brad as his
IRA beneficiary. If Brad subsequently files for bankruptcy, does
the IRA he inherited from his father still qualify as a
retirement fund, exempt from creditors?
The Supreme Court unanimously turned thumbs down. Three
reasons were given for denying that beneficiaries hold protected
First, an IRA beneficiary who inherits can't make additional
contributions to that account. Qualified individuals can put
money into retirement accounts such as traditional IRAs and Roth
IRAs. Tax breaks encourage such outlays.
But inherited IRAs are only for withdrawals.
Second, beneficiaries must take minimum distributions and pay
any resulting tax, regardless of age. "Even a 5-year-old IRA
beneficiary, who certainly isn't retired, must withdraw
something," Slott said.
Third, the 10% early withdrawal penalty doesn't apply to
inherited IRAs. Unless certain exceptions are met, withdrawals
from traditional and Roth IRAs before age 59-1/2 will lead to
"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," the
Supreme Court noted in its opinion.
Turning To A Trust
The bottom line is that the Supreme Court has ruled that
inherited IRAs are much different than traditional or Roth IRAs.
Thus, inherited IRAs don't qualify as retirement funds for a
What does this mean for IRA owners? You might want to evaluate
your current IRA beneficiaries to see if they're likely to run
into financial difficulties.
"Often, IRA beneficiaries are not as careful with the money as
the people who earned it," Slott said.
If you think future financial problems could surface, one
approach is to designate an irrevocable trust as your IRA
beneficiary. The people for whom the money is intended can be
named as trust beneficiaries.
After the IRA passes to a well-crafted trust, the money can
enjoy considerable creditor protection.
But trusts can be expensive to create. And Slott says that a
trust serving as an IRA beneficiary must be drafted by a skilled
lawyer in order to qualify for tax-friendly distribution
The Insurance Solution
"As an alternative," Slott said, "an IRA owner who is
concerned with a beneficiary's creditor exposure could tap the
account and buy life insurance."
Thus, Art Young could withdraw money from his IRA, pay the
required tax, and use the net amount to buy a policy on his life,
held in trust for his son Brad. The life insurance proceeds
probably will avoid income tax as well as the inherited IRA's
minimum distribution rules.
What strategies are available to someone with an inherited IRA
facing financial distress? Moving money from an inherited IRA to
an asset protected under state law might make sense, but such
steps should be taken after consulting with an attorney as to
what will pass judicial review.
Slott points out that the Supreme Court case only covers
bankruptcy filings, not claims by creditors in other disputes.
Some states protect inherited IRAs in other areas.