In Bankruptcy, Inherited IRAs Are Up For Grabs
Are inherited IRAs protected from bankruptcy creditors? Earlier this month, the U.S. Supreme Court said no. (Clark v. Rameker, 6/12/14.)
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 retirement funds 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 support.
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 retirement funds.
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 fines.
"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 bankruptcy exemption.
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 rules.
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.