I inherited an Individual Retirement Account from my aunt. I am 45 years old, and there is $350,000 in the account. What are the rules, and is that money exposed to creditors if I am sued or file for bankruptcy?
Both Roth IRAs and traditional IRAs are enjoying 15-minutes of fame this month in the wake of a United States Supreme Court’s decision in the Clark vs. Rameker case on June 12, 2014. The Court was presented with the question: “Is an inherited IRA protected from the bankruptcy claims of creditors?” On June 12 the Court answered that question with a unanimous “No.”
Specifically, the Court held that funds held in inherited IRAs are not “retirement funds” within the meaning of U.S.C. § 522(b)(3)(c) and therefore are not exempt from the bankruptcy estate. This renders inherited IRA funds to creditor claims in bankruptcy. Traditional and Roth IRAs have typically been exempt from bankruptcy claims up to a $1 million limit ($1,245,475 as adjusted for inflation in 2014).
The United States Circuit Courts of Appeals (the third court to address a bankruptcy case if it is appealed) has taken opposing views on this question. In the Eighth Circuit, inherited IRAs have been exempt from bankruptcy claims on the grounds that the funds are retirement funds in tax-exempt vehicles. Other Circuits have held that inherited IRAs lack the requisite “retirement purpose” and are governed by a different set of rules than IRAs in the hands of their original owners. Inherited IRAs can be liquidated at any time without penalty, unlike an original IRA, which suffers a penalty if the owner withdraws assets before the age of 59-and-a-half.
In the Clark case, Heidi Heffron-Clark inherited an IRA from her mother in 2001, who had named Heidi on the beneficiary designation form. The IRA was worth $450,000 at the mother’s death. Heidi had drawn the account down to approximately $300,000 before filing for Chapter 7 bankruptcy nine years later in October, 2010. Heidi argued that the money constituted “retirement funds” and was not available to creditors. The creditors objected. The bankruptcy court agreed. The U.S. District Court for the Western District of Wisconsin reversed the bankruptcy court and the U.S. Court of Appeals for the Seventh Circuit overturned the District Court decision.
IRA accounts, employer sponsored retirement plans such as 401(k)s and 403(b)s are accounts that an individual creates and funds for himself. The Supreme Court decision turned on the legal distinction between self-funded IRAs and inherited IRAs, whether through an employer-sponsored plan or a roll-over when you leave the company. The Court noted that, unlike IRA owners, inheritors cannot make additional contributions to the account. They can withdraw funds without penalty. By contrast, non-spouse inheritors of an IRA must withdraw the entire account balance in five years of the primary owner’s death or take out a minimum amount each year starting on Dec. 31 of the year after the IRA owner dies. This applies to all inherited IRAs. The Court emphasized this distinction, reasoning that the bankruptcy code provision is intended to ensure that a filer has money during retirement, justifying its protection.
This presents an interesting conundrum for spouses who inherit an IRA. Spousal inherited IRAs receive slightly different treatment. An inheritor spouse can roll over the inherited IRA into her own IRA account and not take distributions until she reaches 70-and-a-half, even if that date is later than the date the decedent spouse would have turned 70-and-a-half. She would not be able to withdraw assets before the age of 59-and-a-half from the commingled IRA. If she elects the roll-over, her own account is not an inherited IRA. If she does not do the roll-over, the inherited IRA is considered such. The spouse in that scenario would not have to withdraw money until the decedent spouse would have turned 70-and-a-half (or immediately assuming the spouse died after he reached that age). Since now, under the Court’s decision, the inherited IRA would not be protected from bankruptcy, this new interpretation militates in favor of spouses rolling over the IRA into their own (or opening one post-haste if they did not have one to begin with).
Naming a creditor-protection trust as a beneficiary is also an option for spouse and non-spouse inheritors alike. The trust will shield the inherited IRA funds from creditors, and can also control a (possibly spendthrift) heir to withdraw the funds in terms of timing and amount. The rules applicable to setting up a trust that will be the recipient of an inherited IRA are complex, and should only be implemented with the assistance of a qualified estate attorney to ensure that your objectives are met and that you understand all the benefits and drawbacks of using a trust.
Alison Arden Besunder is the founding attorney of the law firm of Arden Besunder P.C., where she assists new and not-so-new parents with their estate planning needs. Her firm assists clients in Manhattan, Brooklyn, Queens, Nassau, and Suffolk Counties. You can find Alison Besunder on Twitter @estatetrustplan and on her website at www.besunderlaw.com.