Creditor protection for retirement accounts takes a hit – inherited IRAs not protected in federal bankruptcy
The United States Supreme Court issued a 9-0 decision last month holding that inherited IRAs are not protected under the federal bankruptcy exemptions that can otherwise protect retirement accounts.
In Clark v. Rameker, a Wisconsin pizza shop owner and her husband filed for bankruptcy after their shop fell on hard times. Their main asset was a $300,000 IRA, which was previously inherited from one of their parents. The Clarks believed the $300k was protected under the theory that the account was a “retirement fund”, and thus exempt from creditors. The bankruptcy trustee wanted to instead use the money for the benefit of the couple’s landlord and creditors – who were owed about $700,000.
In an opinion penned by Justice Sotomayor, the Court emphasized that the underlying policy of the bankruptcy code is designed to strike a balance between ensuring creditor’s rights while protecting a debtor’s “essential needs.” The Court was especially disturbed at the notion that a person could go out and buy a sports car or vacation home with the inherited IRA funds right after the bankruptcy proceeding if inherited IRAs were indeed exempt. Noting that inherited IRAs can be withdrawn by beneficiaries at any time with no penalty (beside income tax), and thus are not reserved for essential needs in retirement, the Court ruled against the pizza shop owners, holding that that inherited IRAs are not protected in bankruptcy. The Court’s full opinion can be found here.
Clark’s take-home planning point is this: If the original owner of the IRA (i.e., the pizza shop owner’s mother) had left her the inherited IRA in a properly designed spendthrift trust, rather than outright, the funds would have been excluded from the bankruptcy case (and not reachable by the creditors). Although there are a handful of state bankruptcy exemptions that still protect inherited IRAs (AZ, AK, FL, ID, MO, NC, TX, and OH), most do not, and a trust is the only mechanism to ensure that inherited IRA assets stay out of reach of bankruptcy creditors.
If drafted properly, the IRA Trust (sometimes referred to as the Standalone IRA Trust, the IRA Legacy Trust, the IRS Inheritor’s Trust, the Retirement Asset Protection Trust, or the IRA Preservation Trust) can accomplish the twin goals of (1) preserving the tax benefits of the IRA (i.e., preventing beneficiaries from foolishly taking rapid distributions and incurring large income tax bills); and (2) protecting the account from creditors. For these reasons, I am a huge fan of the IRA Legacy Trust – in the right scenario.
For more information on the power of such planning, see my article “Roth IRA + Legacy Trust: A Match Made in Tax-Free Heaven,” found here [note:Roth IRAs are even better in these situations because they are more effective as a pure wealth-transfer device – mostly because they can grow infinitely until the original IRA owner’s death (i.e., no “required minimum distributions” starting at age 70½) and the future beneficiaries will not owe any incomes tax upon withdrawal, which could be 50 years down the road!].