Bankruptcy Protection for Inherited IRAs?

Jun 27, 2014 | By: Michael Blanchard

Supreme Court Rules on Bankruptcy Protection for Inherited IRAs

Background:

The funding of retirement accounts is nearly always at the top of the list when we make recommendations to clients for investment and saving. Besides the tax benefits, IRAs are protected under federal law if you declare bankruptcy. The exemption is currently $1,245,475. The cap does not apply to amounts rolled over from a qualified employer plan like a 401(k)--these amounts are fully protected under federal law.

For small business owners, who often have a substantial portion of their wealth concentrated in one place, this protection can be important. Over the years, federal court decisions have been divided over whether or not inherited IRAs are protected assets in a bankruptcy. To resolve this conflict, the United States Supreme Court agreed to hear the case of Clark v. Rameker.

The Supreme Court's Decision:

On June 12, the Court decided the Clark case, holding that inherited IRAs are not protected "retirement funds" under federal law. The Court reached this conclusion by noting that the holder of an inherited IRA cannot invest new money in the account, can withdraw the entire balance at any time and use the funds for any reason without penalty, and must take required distributions from the account no matter how far the holder is from retirement.

What this means to you:

If you declare bankruptcy and hold an inherited IRA, you will not receive any protection for those assets under federal law. Whether they receive any protection from creditors at all (inside or outside of bankruptcy) will instead depend on the laws of your particular state.

Note that if you inherit an IRA from your deceased spouse, and you are the sole beneficiary, you are generally entitled to treat that IRA as your own (for example, by making an affirmative election or contributing to the account). If you do so, the IRA should not be considered an inherited IRA for bankruptcy purposes. However, since the Clark case dealt with an IRA inherited by the IRA owner's daughter, and not a spouse, the Court did not specifically address this.

In addition, you should keep this ruling in mind as you name beneficiaries for your own IRAs, particularly if you intend to name someone other than your spouse as beneficiary. If creditor protection for your heirs is important to you, one option is to consider naming a spendthrift trust as your IRA beneficiary. These trusts limit your trust beneficiary's ability to control the trust funds, and provide protection from your beneficiary's creditors under the laws of most states. However, be sure to consult a qualified professional, as establishing a trust as your IRA beneficiary can have significant legal and tax implications.

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