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By:   Sandra L. Clapp
Sandra L. Clapp & Associates, P.A.

It’s official – inherited individual retirement accounts (IRAs) are not protected under federal bankruptcy laws. Prior to 2005, whether a retirement account was exempt in a bankruptcy proceeding was governed by state exemption law or a limited set of exemptions found in the bankruptcy code.  After the bankruptcy code was amended in 2005, whether retirement assets were exempt from creditors in a bankruptcy proceeding was governed by the new bankruptcy code provisions.  The bankruptcy courts have been divided on whether the current bankruptcy act provides an exemption for IRAs that were inherited from another person.  The question was whether the inherited IRA was a “retirement fund” under the bankruptcy code to enable the debtor to claim an exemption on such inherited IRA and not have the inherited IRA included as property or assets of the debtor available to satisfy the creditors.  A recent United States Supreme Court ruling entered in June 2014 resolved the question of whether inherited IRAs are protected as “retirement funds” under the federal bankruptcy code and the answer is no.  Inherited IRAs will now be available as property or assets in a bankruptcy proceeding to satisfy the beneficiary’s creditors.

At this point in your reading you might be asking yourself why this ruling warrants your attention.  If you hold an IRA with funds or assets you have contributed to the account, as the owner of the IRA the law is relatively clear that the IRA is protected from the owner’s creditors.  Upon death of the owner, the IRA will transfer to the beneficiary of the IRA and the IRA is then identified as an inherited IRA because it is an IRA that was originally owned by another and was received through this beneficiary transfer.  If the beneficiary of the inherited IRA has creditor issues, the assets you have accumulated in the IRA will not be protected in a bankruptcy proceeding filed by your beneficiary.  Based upon this recent ruling, it is more important in the estate planning process to consider whether an IRA should be transferred directly to a beneficiary even if the beneficiary does not immediately have creditor issues or whether alternate planning would be appropriate.

It is important to keep in mind that the US Supreme Court ruling will only apply in a bankruptcy proceeding filed by the beneficiary.  If the beneficiary has other creditors that pursue collection under state law, the law of such state may be different and still provide for exemption of the inherited IRA.  The ruling also did not discuss whether the conclusion would have been different if the beneficiary had been a spouse and the IRA had been rolled into an IRA owned by the spouse.  Even if your beneficiary may not have creditor issues today, lawsuits or debts can arise in the future for events such as car accidents or alcohol or drug dependency. Caution would dictate treating the recent US Supreme Court ruling as the guiding principle under which your planning should be structured for an IRA transfer.

With this recent decision favoring creditors, one planning option to consider is to transfer the IRA to a qualified trust.  A qualified spendthrift trust established under state law would enable the trustee to receive the inherited IRA and administer the trust for the beneficiary without the inherited IRA being considered an asset of the beneficiary.  A properly structured trust can also enable the inherited IRA to make distributions over the child’s lifetime if the terms of the trust enable the trustee to “look through” to the individual trust beneficiary for purposes of measuring post-death distributions.  Another option is to name a qualified charitable organization as the beneficiary which will not enable the heirs to receive the funds, but may provide a tax favorable way to satisfy charitable bequests and desires.

This article is not intended to replace legal advice applicable to your situation and should be used only for informational purposes.  Consult with your legal or tax advisors before implementing any suggestion contained herein.


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