By Jeffery Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
In a landmark decision last Thursday, the Supreme Court ruled unanimously, 9-0, that inherited IRAs are not protected in bankruptcy under federal law.
The decision has far reaching ramifications and, depending on your heirs' specific circumstances, may give you pause as to who — or what — is the best beneficiary for your retirement accounts.
A bit of background
In 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). While, on the whole, the law was designed to make filing for bankruptcy less appealing, it had a silver lining for retirement account owners. BAPCPA afforded a great deal of bankruptcy protection to "retirement funds," providing IRAs and Roth IRAs with a cumulative $1 million inflation-adjusted (currently $1,245,475) exemption and employer-sponsored plans with an unlimited exemption.
While that may seem fairly straightforward, the seemingly innocuous use of the phrase "retirement funds" in the bankruptcy statute muddied the waters. Bankruptcy trustees eventually began to challenge the exempt status of inherited IRAs, citing that they weren't "retirement funds" and thus, not protected in bankruptcy under the federal bankruptcy rules. For the past few years, various courts have weighed in on the issue, delivering anything but consistent decisions. Indeed, even the very case brought forth to the Supreme Court and decided last Thursday, Clark v. Rameker, had its own roller coaster of a ride before reaching the High Court.
It started in 2010, when Heidi Heffron-Clark filed for Chapter 7 bankruptcy protection, but listed her inherited IRA, worth about $300,000 at the time, as an exempt asset (unavailable to creditors). The bankruptcy trustee and Clark's creditors objected to this exemption and the Wisconsin bankruptcy court which first heard the case agreed, ruling that Clark's inherited IRA wasn't protected in bankruptcy and was an available asset that could be used to satisfy her creditors. Clark appealed to a federal district court, which reversed the bankruptcy court's initial decision. Later however, the bankruptcy trustee appealed the district court's decision to the 7th Circuit Court of Appeals, which reversed the district court's decision — putting things back to where they had started — once again holding that Clark's inherited IRA wasn't protected.
Ultimately, with few other options, Clark appealed that decision to the Supreme Court, which brings us all the way to last week’s big decision.
The Supreme Court's conundrum
In deciding the Clark case, the primary issue before the Supreme Court was whether or not an inherited IRA is a retirement account. At first glance, that might seem crazy. After all, an inherited IRA is an inherited individual retirement account. It says retirement in the name. That said, there were, in fact, some very fair arguments to be made on both sides of the coin.
On the one hand, if someone owns a house, and that house is left to their child, would anyone argue that it isn't a house anymore? Why should an IRA be any different? If it was a retirement account for the original owner — which no one would dispute — then why should its character change merely because the owner dies?
On the other hand, there are a number of reasons why an inherited IRA should not be considered a "retirement" account and ultimately, the Supreme Court felt these factors outweighed their counterparts. Specifically, the Supreme Court felt the following characteristics of inherited IRAs weren't characteristics of a "retirement" account:
- Beneficiaries cannot add money to inherited IRAs like IRA owners can to their own accounts.
- Beneficiaries of inherited IRAs must generally begin to take RMDs (required minimum distributions) in the year after they inherit the account, regardless of how far away they are from retirement. For instance, a grandchild that inherits an IRA at one-year old must begin taking RMDs by the time they are two. It's hard to see how that can be for their retirement.
- Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty. IRA owners must generally wait until 59 ½ before they can take penalty-free distributions.
Relying largely on these items, the Supreme Court decided that inherited IRAs don't contain "retirement funds" and, as a result, the favorable bankruptcy protection afforded to such funds under the federal bankruptcy code should not be extended to them.
Does this decision apply to all inherited IRAs?
Although the Supreme Court's decision doesn't explicitly state one way or another, its ruling seems to be limited to IRAs inherited by someone other than a spouse. There are a number of special rules for spousal beneficiaries under the tax code, including the ability for a surviving spouse to rollover a decedent's IRA into their own IRA. In fact, during oral arguments, the bankruptcy trustee's attorney even made a point to distinguish Clark's inherited IRA from that of a surviving spouse.
So, while making any assumptions in this area can be dangerous, it would appear, at least for now, that an IRA inherited from one's spouse would maintain its exempt status under the federal bankruptcy laws.
What can you do to protect your funds
The question for many now is, "How can I keep my hard-earned money away from my children's (or other beneficiaries') creditors after I'm gone?"
For some, state law may provide protection. The Supreme Court's decision didn't say that inherited IRAs can't be protected in bankruptcy, but rather, that they are not protected from bankruptcy under the federal bankruptcy statutes. That doesn't, however, preclude states from offering bankruptcy protection — or, for that matter, creditor protection in non-bankruptcy situations — to inherited IRAs under state law.
In fact, during the last three years alone, while the courts have been bouncing back and forth on this issue, no less than seven states have adopted laws expressly exempting inherited IRAs under state bankruptcy statutes. If you're an IRA beneficiary with angry creditors and you're lucky enough to live in one of these states, you may be able to shield your inherited IRAs despite your money woes.
In most states, though — at least for now — inherited IRAs and other retirement accounts aren't afforded any special protections. In such cases, there are certainly a number of different approaches you might consider to protect your hard-earned retirement funds after you're gone. Perhaps the most obvious approach though, especially in situations where bankruptcy or general creditor protection for your beneficiaries is a significant, real concern, is to name a trust as your IRA beneficiary.
If — and this is a big if — a trust is drafted properly, certain requirements are met and the trust contains appropriate spendthrift language, it can help shield the trust assets (like an inherited IRA) from your trust beneficiaries' creditors while still allowing the trust to stretch distributions from the inherited IRA out over the oldest applicable trust beneficiary's life expectancy.
There are a lot of potential downsides to consider when naming a trust as your IRA beneficiary, though, including: Increased tax burden due to the compressed trust tax brackets, ongoing accounting and trustee fees and their sheer complexity. So arbitrarily naming a trust as your IRA beneficiary probably isn't best either. There's little question that a properly drafted trust serving as an IRA beneficiary affords greater creditor and bankruptcy protection for your heirs, but because there are also downsides to using them, whether or not you should do so becomes a complex decision that should take into consideration many factors, including the size of your IRA and how likely it is that your beneficiaries will face creditor issues.
Should you be faced with such a decision at some point in the future, it's probably best to consult with both an attorney with expertise in the IRA area, as well as a tax professional with sufficient IRA and trust accounting knowledge. It may sound silly, but you only get one shot to get things right and protect as much of your wealth as possible for your heirs once you're gone, so plan ahead, do your research and make an informed decision that's right for you, your beneficiaries and your peace of mind.
What do you think of the Supreme Court's decision? Should inherited IRAs be protected in bankruptcy or should they be available to creditors to satisfy outstanding debts? Please comment below or tweet me @IRAGuru4EdSlott to let me know your thoughts.