Inherited IRAs Not Exempt from Bankruptcy Protection

On June 12, 2014, the United States Supreme Court issued a decision holding that Inherited Individual Retirement Accounts (Inherited IRAs) are not exempt from creditors in a bankruptcy proceeding.  In Clark v. Rameker, Trustee, Justice Sonia Sotomayor, writing the majority opinion, stated that the change in the status of such accounts upon the death of their original owner make them less like retirement savings and more like a source of assets which can be available to repay creditors.  She stated that if the court were to hold otherwise nothing could prevent a debtor from discharging her obligations then spending the entire balance of an inherited IRA “on a vacation home or a sports car immediately after her bankruptcy proceedings are complete.”

To substantiate its holding, the court held, “The ordinary meaning of ‘retirement funds’ is properly understood to be sums of money set aside for the day an individual stops working. Three legal characteristics of inherited IRAs provide objective evidence that they do not contain such funds. First, the holder of an inherited IRA may never invest additional money in the account. 26 U. S.C. §219(d)(4). Second, holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. §§408(a)(6), 401(a)(9)(B). Finally, the holder of an inherited IRA may withdraw the entire balance of the account at anytime—and use it for any purpose—without penalty.”

For many individuals, one of the largest, if not the largest, asset in their estate is their IRA.  When planning to distribute these assets in their estate plan, the customary practice is for one to distribute to their spouse, if applicable, then outright to one or more of their children.  Prior to this case, one could argue that an inherited IRA was protected.  Obviously, that is no longer the case.

The case underscores the point that one needs to thoughtfully plan regarding the manner in which his or her heirs inherit, especially if those heirs are children.  In doing so, one has to realistically assess the financial condition of such children.  If a child has a history of financial problems, there are alternatives to direct distribution of IRA proceeds.  One can be to that child’s portion placed into a spendthrift trust to insure that he or she has access to funds but that same are exempt from creditors.  This strategy should be effective in that the trust is considered to be a separate legal entity than the child.  Another alternative is to direct the IRA assets to other children or beneficiaries and compensate the other child by placing other assets into his or her spendthrift trust.  In all, this case underscores the need to avoid a “fill in the blank” mentality when distributing non-probate assets such as IRAs and life insurance, and to have to inheritance of same intertwined with a thoughtful estate plan.

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