When someone with a tax-deferred retirement plan passes away, it’s generally the case that the proceeds are left to a beneficiary named to the account. IRAs and other retirement plans operate outside of wills and trusts that are set up for the transfer of assets upon an owner’s death, and in those cases, the proceeds are transferred directly to the named account beneficiaries. While retirement plans generally enjoy bankruptcy protection at the federal level, a U.S. Supreme Court ruling earlier this year has cleared up a longstanding disagreement among financial and legal professionals regarding the protection associated with “inherited IRAs,” and it’s not good news for those who own inherited IRAs.
The extension of bankruptcy and other types of asset protection to inherited IRAs has been controversial, because inherited IRAs do not have the same, key features that characterize one’s originally-owned retirement plan, like the ability to make ongoing contributions (inherited IRA owners cannot make further contributions into those plans), or the inability to make early withdrawals (before age 59 ½) without a penalty. The Supreme Court, in a 9-0 decision, essentially said that absent these two significant components, inherited IRAs are not really retirement plans in the way the bankruptcy exemption imagines them to be – the money has not been set aside by the debtor to fund his own retirement, so it is, according to the Court, just a windfall like any other inherited funds. As a matter of fact, on the subject of withdrawals, not only can inherited IRA owners take out funds penalty-free, they are required to take out either the full account value over a five-year period or a minimum distribution annually. The point is that the features of inherited IRAs are not suggestive of saving for retirement in the classic sense, and the Court seized upon this as the basis for distinguishing inherited IRAs from others for the purpose of the federal bankruptcy exemption.
The original case that gave rise to the Court’s decision concerned an adult child who was the beneficiary of her mother’s IRA. When mom passed away in 2001, the account was retained as an inherited IRA by the daughter; when she filed for bankruptcy in 2010, the inherited IRA was listed as an exempt asset, and the tug-of-war between the daughter and her creditors began from there, culminating in the Supreme Court case decided earlier this year.
Before we proceed, it must be mentioned that there are seven states that have previously taken it upon themselves to create specific exemptions for inherited IRAs, so that they may remain out of reach of creditors looking for satisfaction in bankruptcy cases – the states are: Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas. If you are a resident of one of these states, your inherited IRA is basically exempt from creditors, but you would still do well to spend a few bucks and bend the ear of an asset protection attorney in order to be perfectly clear about any limitations to the state protections offered to your inherited IRA, particularly if the account value is substantial.
It’s important, as well, to make a distinction between those IRAs inherited by spouses and those inherited by children or other non-spouses. Spouses have the option to roll over the account from an inherited IRA to an IRA in his/her own name exclusively (inherited IRAs are titled in the name of the original owner, with a further “FBO” designation made in the full title on behalf of the beneficiary who received the IRA), but non-spouses do not have that option. Given the Court ruling, it would be prudent for spousal beneficiaries to convert their inherited IRAs to rollover IRAs in their own names, because once THAT happens, bankruptcy protection of that IRA would exist.
Non-spouse beneficiaries don’t have the luxury of converting, and for those for whom bankruptcy appears to be a remote possibility, it may not be a big deal, but for others, they may have something to consider. Unfortunately, for those non-spouse beneficiaries who’ve already inherited the IRA, there’s presently little that appears can be done to protect that money intact. On this point, an attorney who specializes in asset protection should be consulted to see what steps might be taken to configure the money in the inherited IRA in such a way that it comes to enjoy greater asset protection; it might mean moving the funds from the inherited IRA to another type of account…like an acceptable form of asset protection trust…in order to keep the money at bay from potential creditors.
All of this said, it’s smart that one not overreact to the Supremes’ decision; while no one can know, for sure, what kind of trouble is around the corner, if your risk profile is generally very low, it may not be worth it for you to take drastic steps to move the money out of the existing inherited IRA and incur the tax consequences associated with doing so…but that’s a determination best left to you, your attorney, and your financial adviser. As for those non-spouses who know in advance they’re likely to inherit an IRA from a remaining parent or other account owner, steps can be taken before that owner passes to better protect the money – for example, an IRA’s original owner can name a trust as the beneficiary, rather than an individual, and this trust mechanism can go a long way to preserving the protection that dissolves when the inherited IRA is left to an individual directly. Again, though, an asset protection attorney should be consulted to clarify if this is a good move for both the IRA owner as well as the trust’s expected beneficiaries, based on the wishes and profiles of each party.
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