The Supreme Court's recent 9-0, unanimous ruling regarding inherited individual retirement accounts has important ramifications for spouses. In a landmark decision, this summer, it ruled that an inherited IRA is not protected in bankruptcy under federal law.
Justice Sonia Sotomayor wrote the opinion explaining that Heidi Heffron-Clark, who inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later, could not shield the account from her creditors because the funds were not earmarked exclusively for retirement.
At first glance, this decision may seem counter intuitive. After all, retirement is in the name, inherited individual retirement account. If all retirement accounts are protected in bankruptcy, shouldn't this apply to inherited IRAs as well?
Upon closer inspection, there are a number of reasons why inherited IRAs should not be considered retirement accounts. The Supreme Court said these factors outweighed any counter arguments.
• Beneficiaries cannot add money to inherited IRAs like IRA owners can to their accounts.
• Beneficiaries of inherited IRAs must generally begin to make required minimum distributions (RMDs) in the year after they inherit the accounts, regardless of how far away they are from 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 age 59 ½ before they can take penalty-free distributions.
Pointing to these distinctions, the Supreme Court determined that inherited IRAs do not contain funds dedicated exclusively for use by individuals during retirement. As a result, the favorable bankruptcy protection afforded to retirement funds under the federal bankruptcy code does not apply.
The decision has important ramifications for spouses. Spouses who inherit IRAs have an option not available to other inheritors. They can roll the assets into their own IRAs and postpone distributions from the traditional IRA until age 70 ½. The catch is, like other IRA owners, they may have to pay a 10% early-withdrawal penalty if money is taken before age 59 ½. Unless the rollover is done however, the accounts are considered inherited IRAs and those assets will not be protected in bankruptcy. Although the court did not rule specifically on the impact of a spousal rollover on creditor protection, a convincing argument can be made that a rolled-over IRA — with the funds designated for retirement funding — deserves the same level of protection as when it was in the original owner's hands.
ROLLOVERS VS. TRUSTS
Another way to safeguard IRA assets from creditors, which can be used to benefit spouses or anyone else, is to name trusts, rather than people, as beneficiaries of the IRAs. IRAs left to irrevocable trusts will have a greater chance of being protected from the claims of the new account owners' creditors and also from the claims of creditors of the trust beneficiaries.
Using trusts can also provide other benefits. This includes enabling the inheritors to use the oldest beneficiary's life expectancy to stretch out the tax-deferred growth. They also have control over when the beneficiaries are to receive distributions and the ability to provide for special needs. In addition, trusts can protect the assets from future lawsuits, irresponsible spending and divorce proceedings.
Previously, naming trusts as beneficiaries was a popular strategy to protect IRA assets from creditors. However, complex rules govern this approach and it should not be attempted without guidance from estate tax law experts.
INFORMED GUIDANCE IS KEY
Given the amount of wealth held inside retirement accounts and the advancing age of many investors holding IRAs, advisers need to be adept at helping their clients figure out who or what to name as beneficiaries of these special assets. Also, what steps to take when these accounts transfer. The Clark decision has amplified the need for advisers and investors to become knowledgeable about the handling of inherited retirement assets.
Robert Cirrotti is a director for Pershing, a BNY Mellon company, where he leads Retirement Solutions.